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Table of Content

DEMAND AND SUPPLY 01 MARKET STRUCTURES 07 NATIONAL INCOME 25 NATIONAL INCOME MEASUREMENT 28 THE CLASSICAL THEORY OF EMPLOYMENT: ASSUMPTION AND CRITICISM 29 THE KEYNESIAN THEORY OF INCOME, OUTPUT AND EMPLOYMENT 47 CONSUMPTION FUNCTION 53 INVESTMENT FUNCTION IN AN ECONOMY 74 MULTIPLIER EFFECT 79 ACCELERATOR 83 INTERACTION BETWEEN MULTIPLIER AND ACCELERATOR 92 FUNCTIONS OF MONEY 96 DEMAND FOR MONEY 97 SUPPLY OF MONEY 99 IS-LM 102 THE PHILLIPS CURVE 125 BUSINESS CYCLES 130 BALANCE OF PAYMENT 134

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MONETARY POLICY 137 FISCAL POLICY 143 ROLE OF FISCAL POLICY IN CONTROLLING INFLATION 147 NON-BANKING FINANCIAL COMPANY 149

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DEMAND AND SUPPLY

Supply and demand form the most fundamental concepts of economics. Whether you are an academic, farmer, pharmaceutical manufacturer, or simply a consumer, the basic premise of supply and demand equilibrium is integrated into your daily actions. Only after understanding the basics of these models can the more complicated aspects of economics be mastered.

DEMAND Although most explanations typically focus on explaining the concept of supply first, understanding demand is more intuitive for many, and thus helps with subsequent descriptions.

As the price of a good increase, the demand for the product will—except for a few obscure situations—decrease. For purposes of our discussion, let's assume the product in question is a television set. If TVs are sold for the cheap price of $5 each, then a large number of consumers will purchase them at a high frequency. Most people would even buy more TVs than they need, putting one in every room and perhaps even some in storage.

Essentially, because everyone can easily afford a TV, the demand for these products will remain high. On the other hand, if the price of a television set is $50,000, this gadget will be a rare consumer product as only the wealthy will be able to afford the purchase. While most people would still like to buy TVs, at that price, demand for them would be extremely low.

Of course, the above examples take place in a vacuum. A pure example of a demand model assumes several conditions. First, product differentiation does not exist—there is only one type of product sold at a single price to every consumer. Second, in this closed scenario, the item in question is a basic want and not an essential human necessity such as food (although having a TV provides a definite level of utility, it is not an absolute requirement). Third, the good does not have a substitute and consumers expect prices to remain stable into the future.

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SUPPLY The supply curve functions in a similar fashion, but it considers the

relationship between the price and available supply of an item from the perspective of the producer rather than the consumer.

When prices of a product increase, producers are willing to manufacture more of the product to realize greater profits. Likewise, falling prices depress production as producers may not be able to cover their input costs upon selling the final good. Going back to the example of the television set, if the input costs to produce a TV are set at $50 plus the variable costs of labor, production would be highly unprofitable when the selling price of the TV drops below the $50 mark.

On the other hand, when prices are higher, producers are encouraged to increase their levels of activity to reap more benefit. For example, if television prices are $1,000, manufacturers can focus on producing television sets in addition to other possible ventures. Keeping all variables the same but increasing the selling price of the TV to $50,000 would benefit the producers and provide the incentive to build more TVs. The behavior to seek maximum amounts of profits forces the supply curve to be upward sloping.

An underlying assumption of the theory lies in the producer taking on the role of a price taker. Rather than dictating prices of the product, this input is determined by the market and suppliers only face the decision of how much to actually produce, given the market price. Similar to the demand curve, optimal scenarios are not always the case, such as in monopolistic markets.

Finding an Equilibrium Consumers typically look for the lowest cost, while producers are

encouraged to increase outputs only at higher costs. Naturally, the ideal price a consumer would pay for a good would be "zero dollars." However, such a phenomenon is unfeasible as producers would not be able to stay in business. Producers, logically, seek to sell their products for as much as possible. However, when prices become unreasonable, consumers will change their preferences and move away from the product. A proper balance must be achieved whereby both parties are able to engage in ongoing business transactions to the benefit of consumers and producers. (Theoretically, the optimal price that results in producers and consumers achieving the maximum level of combined utility occurs at the price where

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the supply and demand lines intersect. Deviations from this point result in an overall loss to the economy commonly referred to as a deadweight loss.

Law or Theory? The law of supply and demand is actually an economic theory that

was popularized by Adam Smith in 1776. The principles of supply and demand have been shown to be very effective in predicting market behavior. However, there are multiple other factors that affect markets on both a microeconomic and a macroeconomic level. Supply and demand heavily guide market behavior, but do not outright determine it.

Another way of looking at the laws of supply and demand is by considering them a guide. While they are only two factors influencing market conditions, they are very important factors. Smith referred to them as the invisible hand that guides a free market. However, if the economic environment is not a free market, supply and demand are not nearly as influential. In socialist economic systems, the government typically sets prices for commodities, regardless of the supply or demand conditions.

This creates problems because the government is not always able to control supply or demand. This is evident when examining Venezuela's food shortages and high inflation rates from 2010. The country attempted to take over the food supply from private vendors and establish price controls but suffered crippling shortages and accusations of corruption as a result. Supply and demand still very much affected the situation in Venezuela but were not the only influences.

The principles of supply and demand have been illustrated repeatedly over centuries of different market conditions. However, the current economy is more global than it has ever been, and macroeconomic forces can be difficult to predict. Supply and demand are effective indicators, but not concrete predictors.

The theory of supply and demand relates not only to physical products such as television sets and jackets but also to wages and the movement of labor. More advanced theories of micro and macroeconomics often adjust the assumptions and appearance of the supply and demand curve to properly illustrate concepts like economic surplus, monetary policy, externalities, aggregate supply, fiscal stimulation, elasticity, and shortfalls. Before studying those more complex issues, the basics of supply and demand must be properly understood.

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Understanding the Law of Supply and Demand The law of supply and demand, one of the most basic economic laws,

ties into almost all economic principles in some way. In practice, supply and demand pull against each other until the market finds an equilibrium price. However, multiple factors can affect both supply and demand, causing them to increase or decrease in various ways. It was extensively studied by Murray N. Rothbard.

Law of Demand vs. Law of Supply The law of demand states that, if all other factors remain equal, the

higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.

Shifts vs. Movement For economics, the "movements" and "shifts" in relation to the supply

and demand curves represent very different market phenomena.

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A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

Meanwhile, a shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

How Do Supply and Demand Create an Equilibrium Price? Also called a market-clearing price, the equilibrium price is the price

at which the producer can sell all the units he wants to produce and the buyer can buy all the units he wants.

At any given point in time, the supply of a good brought to market is fixed. In other words the supply curve in this case is a vertical line, while the

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demand curve is always downward sloping due to the law of diminishing marginal utility. Sellers can charge no more than the market will bear based on consumer demand at that point in time. Over time however, suppliers can increase or decrease the quantity they supply to the market based on the price they expect to be able to charge. So over time the supply curve slopes upward; the more suppliers expect to be able to charge, the more they will be willing to produce and bring to market.

With an upward sloping supply curve and a downward sloping demand curve it is easy to visualize that at some point the two will intersect. At this point, the market price is sufficient to induce suppliers to bring to market that same quantity of goods that consumers will be willing to pay for at that price. Supply and demand are balanced, or in equilibrium. The precise price and quantity where this occurs depends on the shape and position of the respective supply and demand curves, each of which can be influenced by a number of factors.

Factors Affecting Supply Production capacity, production costs such as labor and materials,

and the number of competitors directly affect how much supply businesses can create. Ancillary factors such as material availability, weather, and the reliability of supply chains also can affect supply.

Factors Affecting Demand The number of available substitutes, consumer preferences, and the

shifts in the price of complementary products affect demand. For example, if the price of video game consoles drops, the demand for games for that console may increase as more people buy the console and want games for it.

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MARKET STRUCTURES

Market structure refers to the nature and degree of competition in

the market for goods and services. The structures of market both for goods

market and service (factor) market are determined by the nature of

competition prevailing in a particular market.

Characteristics of Market:

The essential features of a market are:

(1) An Area:

In economics, a market does not mean a particular place but the whole

region where sellers and buyers of a product ate spread. Modem modes of

communication and transport have made the market area for a product

very wide.

(2) One Commodity:

In economics, a market is not related to a place but to a particular product.

Hence, there are separate markets for various commodities. For example,

there are separate markets for clothes, grains, jewellery, etc.

(3) Buyers and Sellers:

The presence of buyers and sellers is necessary for the sale and purchase of

a product in the market. In the modem age, the presence of buyers and

sellers is not necessary in the market because they can do transactions of

goods through letters, telephones, business representatives, internet, etc.

(4) Free Competition:

There should be free competition among buyers and sellers in the market.

This competition is in relation to the price determination of a product

among buyers and sellers.

(5) One Price:

The price of a product is the same in the market because of free competition

among buyers and sellers.

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On the basis of above elements of a market, its general definition

may be as follows:

The market for a product refers to the whole region where buyers and

sellers of that product are spread and there is such free competition that

one price for the product prevails in the entire region.

Market Structure:

Meaning:

Market structure refers to the nature and degree of competition in the

market for goods and services. The structures of market both for goods

market and service (factor) market are determined by the nature of

competition prevailing in a particular market.

Determinants:

There are a number of determinants of market structure for a particular

good.

They are:

(1) The number and nature of sellers.

(2) The number and nature of buyers.

(3) The nature of the product.

(4) The conditions of entry into and exit from the market.

(5) Economies of scale.

They are discussed as under:

1. Number and Nature of Sellers:

The market structures are influenced by the number and nature of sellers in

the market. They range from large number of sellers in perfect competition

to a single seller in pure monopoly, to two sellers in duopoly, to a few sellers

in oligopoly, and to many sellers of differentiated products.

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2. Number and Nature of Buyers:

The market structures are also influenced by the number and nature of

buyers in the market. If there is a single buyer in the market, this is buyer’s

monopoly and is called monopsony market. Such markets exist for local

labour employed by one large employer. There may be two buyers who act

jointly in the market. This is called duopsony market. They may also be a

few organised buyers of a product.

This is known as oligopsony. Duopsony and oligopsony markets are usually

found for cash crops such as rice, sugarcane, etc. when local factories

purchase the entire crops for processing.

3. Nature of Product:

It is the nature of product that determines the market structure. If there is

product differentiation, products are close substitutes and the market is

characterised by monopolistic competition. On the other hand, in case of no

product differentiation, the market is characterised by perfect competition.

And if a product is completely different from other products, it has no close

substitutes and there is pure monopoly in the market.

4. Entry and Exit Conditions:

The conditions for entry and exit of firms in a market depend upon

profitability or loss in a particular market. Profits in a market will attract

the entry of new firms and losses lead to the exit of weak firms from the

market. In a perfect competition market, there is freedom of entry or exit of

firms.

But in monopoly and oligopoly markets, there are barriers to entry of new

firms. Usually, governments have a monopoly in public utility services like

postal, air and road transport, water and power supply services, etc. By

granting exclusive franchises, entries of new supplies are barred. In

oligopoly markets, there are barriers to entry of firms because of collusion,

tacit agreements, cartels, etc. On the other hand, there are no restrictions in

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entry and exit of firms in monopolistic competition due to product

differentiation.

5. Economies of Scale:

Firms that achieve large economies of scale in production grow large in

comparison to others in an industry. They tend to weed out the other firms

with the result that a few firms are left to compete with each other. This

leads to the emergency of oligopoly. If only one firm attains economies of

scale to such a large extent that it is able to meet the entire market demand,

there is monopoly.

Forms of Market Structure:

On the basis of competition, a market can be classified in the

following ways:

1. Perfect Competition

2. Monopoly

3. Duopoly

4. Oligopoly

5. Monopolistic Competition

1. Perfect Competition Market:

A perfectly competitive market is one in which the number of buyers and

sellers is very large, all engaged in buying and selling a homogeneous

product without any artificial restrictions and possessing perfect knowledge

of market at a time. In the words of A. Koutsoyiannis, “Perfect competition

is a market structure characterised by a complete absence of rivalry among

the individual firms.” According to R.G. Lipsey, “Perfect competition is a

market structure in which all firms in an industry are price- takers and in

which there is freedom of entry into, and exit from, industry.”

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Characteristics of Perfect Competition:

The following are the conditions for the existence of perfect competition:

(1) Large Number of Buyers and Sellers:

The first condition is that the number of buyers and sellers must be so large

that none of them individually is in a position to influence the price and

output of the industry as a whole. The demand of individual buyer relative

to the total demand is so small that he cannot influence the price of the

product by his individual action.

Similarly, the supply of an individual seller is so small a fraction of the total

output that he cannot influence the price of the product by his action alone.

In other words, the individual seller is unable to influence the price of the

product by increasing or decreasing its supply.

Rather, he adjusts his supply to the price of the product. He is “output

adjuster”. Thus no buyer or seller can alter the price by his individual

action. He has to accept the price for the product as fixed for the whole

industry. He is a “price taker”.

(2) Freedom of Entry or Exit of Firms:

The next condition is that the firms should be free to enter or leave the

industry. It implies that whenever the industry is earning excess profits,

attracted by these profits some new firms enter the industry. In case of loss

being sustained by the industry, some firms leave it.

(3) Homogeneous Product:

Each firm produces and sells a homogeneous product so that no buyer has

any preference for the product of any individual seller over others. This is

only possible if units of the same product produced by different sellers are

perfect substitutes. In other words, the cross elasticity of the products of

sellers is infinite.

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No seller has an independent price policy. Commodities like salt, wheat,

cotton and coal are homogeneous in nature. He cannot raise the price of his

product. If he does so, his customers would leave him and buy the product

from other sellers at the ruling lower price.

The above two conditions between themselves make the average revenue

curve of the individual seller or firm perfectly elastic, horizontal to the X-

axis. It means that a firm can sell more or less at the ruling market price but

cannot influence the price as the product is homogeneous and the number

of sellers very large.

(4) Absence of Artificial Restrictions:

The next condition is that there is complete openness in buying and selling

of goods. Sellers are free to sell their goods to any buyers and the buyers are

free to buy from any sellers. In other words, there is no discrimination on

the part of buyers or sellers.

Moreover, prices are liable to change freely in response to demand-supply

conditions. There are no efforts on the part of the producers, the

government and other agencies to control the supply, demand or price of

the products. The movement of prices is unfettered.

(5) Profit Maximisation Goal:

Every firm has only one goal of maximising its profits.

(6) Perfect Mobility of Goods and Factors:

Another requirement of perfect competition is the perfect mobility of goods

and factors between industries. Goods are free to move to those places

where they can fetch the highest price. Factors can also move from a low-

paid to a high-paid industry.

(7) Perfect Knowledge of Market Conditions:

This condition implies a close contact between buyers and sellers. Buyers

and sellers possess complete knowledge about the prices at which goods are

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being bought and sold, and of the prices at which others are prepared to

buy and sell. They have also perfect knowledge of the place where the

transactions are being carried on. Such perfect knowledge of market

conditions forces the sellers to sell their product at the prevailing market

price and the buyers to buy at that price.

(8) Absence of Transport Costs:

Another condition is that there are no transport costs in carrying of product

from one place to another. This condition is essential for the existence of

perfect competition which requires that a commodity must have the same

price everywhere at any time. If transport costs are added to the price of the

product, even a homogeneous commodity will have different prices

depending upon transport costs from the place of supply.

(9) Absence of Selling Costs:

Under perfect competition, the costs of advertising, sales-promotion, etc.

do not arise because all firms produce a homogeneous product.

Perfect Competition vs Pure Competition:

Perfect competition is often distinguished from pure competition, but

they differ only in degree. The first five conditions relate to pure

competition while the remaining four conditions are also required for the

existence of perfect competition. According to Chamberlin, pure

competition means, competition unalloyed with monopoly elements,”

whereas perfect competition involves perfection in many other respects

than in the absence of monopoly.” The practical importance of perfect

competition is not much in the present times for few markets are perfectly

competitive except those for staple food products and raw materials. That is

why, Chamberlin says that perfect competition is a rare phenomenon.”

Though the real world does not fulfil the conditions of perfect competition,

yet perfect competition is studied for the simple reason that it helps us in

understanding the working of an economy, where competitive behaviour

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leads to the best allocation of resources and the most efficient organisation

of production. A hypothetical model of a perfectly competitive industry

provides the basis for appraising the actual working of economic

institutions and organisations in any economy.

2. Monopoly Market:

Monopoly is a market situation in which there is only one seller of a

product with barriers to entry of others. The product has no close

substitutes. The cross elasticity of demand with every other product is very

low. This means that no other firms produce a similar product. According

to D. Salvatore, “Monopoly is the form of market organisation in which

there is a single firm selling a commodity for which there are no close

substitutes.” Thus the monopoly firm is itself an industry and the

monopolist faces the industry demand curve.

The demand curve for his product is, therefore, relatively stable and slopes

downward to the right, given the tastes, and incomes of his customers. It

means that more of the product can be sold at a lower price than at a higher

price. He is a price-maker who can set the price to his maximum advantage.

However, it does not mean that he can set both price and output. He can do

either of the two things. His price is determined by his demand curve, once

he selects his output level. Or, once he sets the price for his product, his

output is determined by what consumers will take at that price. In any

situation, the ultimate aim of the monopolist is to have maximum profits.

Characteristics of Monopoly:

The main features of monopoly are as follows:

1. Under monopoly, there is one producer or seller of a particular

product and there is no difference between a firm and an industry.

Under monopoly a firm itself is an industry.

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2. A monopoly may be individual proprietorship or partnership or joint

stock company or a cooperative society or a government company.

3. A monopolist has full control on the supply of a product. Hence, the

elasticity of demand for a monopolist’s product is zero.

4. There is no close substitute of a monopolist’s product in the market.

Hence, under monopoly, the cross elasticity of demand for a

monopoly product with some other good is very low.

5. There are restrictions on the entry of other firms in the area of

monopoly product.

6. A monopolist can influence the price of a product. He is a price-

maker, not a price-taker.

7. Pure monopoly is not found in the real world.

8. Monopolist cannot determine both the price and quantity of a

product simultaneously.

9. Monopolist’s demand curve slopes downwards to the right. That is

why, a monopolist can increase his sales only by decreasing the price

of his product and thereby maximise his profit. The marginal revenue

curve of a monopolist is below the average revenue curve and it falls

faster than the average revenue curve. This is because a monopolist

has to cut down the price of his product to sell an additional unit.

3. Duopoly:

Duopoly is a special case of the theory of oligopoly in which there are only

two sellers. Both the sellers are completely independent and no agreement

exists between them. Even though they are independent, a change in the

price and output of one will affect the other, and may set a chain of

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reactions. A seller may, however, assume that his rival is unaffected by what

he does, in that case he takes only his own direct influence on the price.

If, on the other hand, each seller takes into account the effect of his policy

on that of his rival and the reaction of the rival on himself again, then he

considers both the direct and the indirect influences upon the price.

Moreover, a rival seller’s policy may remain unaltered either to the amount

offered for sale or to the price at which he offers his product. Thus the

duopoly problem can be considered as either ignoring mutual dependence

or recognising it.

4. Oligopoly:

Oligopoly is a market situation in which there are a few firms selling

homogeneous or differentiated products. It is difficult to pinpoint the

number of firms in ‘competition among the few.’ With only a few firms in

the market, the action of one firm is likely to affect the others. An oligopoly

industry produces either a homogeneous product or heterogeneous

products.

The former is called pure or perfect oligopoly and the latter is called

imperfect or differentiated oligopoly. Pure oligopoly is found primarily

among producers of such industrial products as aluminium, cement,

copper, steel, zinc, etc. Imperfect oligopoly is found among producers of

such consumer goods as automobiles, cigarettes, soaps and detergents, TVs,

rubber tyres, refrigerators, typewriters, etc.

Characteristics of Oligopoly:

In addition to fewness of sellers, most oligopolistic industries have several

common characteristics which are explained below:

(1) Interdependence:

There is recognised interdependence among the sellers in the oligopolistic

market. Each oligopolist firm knows that changes in its price, advertising,

product characteristics, etc. may lead to counter-moves by rivals. When the

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sellers are a few, each produces a considerable fraction of the total output of

the industry and can have a noticeable effect on market conditions.

He can reduce or increase the price for the whole oligopolist market by

selling more quantity or less and affect the profits of the other sellers. It

implies that each seller is aware of the price-moves of the other sellers and

their impact on his profit and of the influence of his price-move on the

actions of rivals.

Thus there is complete interdependence among the sellers with regard to

their price-output policies. Each seller has direct and ascertainable

influences upon every other seller in the industry. Thus, every move by one

seller leads to counter-moves by the others.

(2) Advertisement:

The main reason for this mutual interdependence in decision making is that

one producer’s fortunes are dependent on the policies and fortunes of the

other producers in the industry. It is for this reason that oligopolist firms

spend much on advertisement and customer services.

As pointed out by Prof. Baumol, “Under oligopoly advertising can become a

life-and-death matter.” For example, if all oligopolists continue to spend a

lot on advertising their products and one seller does not match up with

them he will find his customers gradually going in for his rival’s product. If,

on the other hand, one oligopolist advertises his product, others have to

follow him to keep up their sales.

(3) Competition:

This leads to another feature of the oligopolistic market, the presence of

competition. Since under oligopoly, there are a few sellers, a move by one

seller immediately affects the rivals. So each seller is always on the alert and

keeps a close watch over the moves of its rivals in order to have a counter-

move. This is true competition.

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(4) Barriers to Entry of Firms:

As there is keen competition in an oligopolistic industry, there are no

barriers to entry into or exit from it. However, in the long run, there are

some types of barriers to entry which tend to restraint new firms from

entering the industry.

They may be:

(a) Economies of scale enjoyed by a few large firms; (b) control over

essential and specialised inputs; (c) high capital requirements due to plant

costs, advertising costs, etc. (d) exclusive patents and licenses; and (e) the

existence of unused capacity which makes the industry unattractive. When

entry is restricted or blocked by such natural and artificial barriers, the

oligopolistic industry can earn long-run super normal profits.

(5) Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size of

firms. Finns differ considerably in size. Some may be small, others very

large. Such a situation is asymmetrical. This is very common in the

American economy. A symmetrical situation with firms of a uniform size is

rare.

(6) Demand Curve:

It is not easy to trace the demand curve for the product of an oligopolist.

Since under oligopoly the exact behaviour pattern of a producer cannot be

ascertained with certainty, his demand curve cannot be drawn accurately,

and with definiteness. How does an individual seller s demand curve look

like in oligopoly is most uncertain because a seller’s price or output moves

lead to unpredictable reactions on price-output policies of his rivals, which

may have further repercussions on his price and output.

The chain of action reaction as a result of an initial change in price or

output, is all a guess-work. Thus a complex system of crossed conjectures

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emerges as a result of the interdependence among the rival oligopolists

which is the main cause of the indeterminateness of the demand curve.

If the oligopolist seller does not have a definite demand curve for his

product, then how does he affect his sales. Presumably, his sales depend

upon his current price and those of his rivals. However, a number of

conjectural demand curves can be imagined.

For example, in differentiated oligopoly where each seller fixes a separate

price for his product, a reduction in price by one seller may lead to an

equivalent, more, less or no price reduction by rival sellers. In each case, a

demand curve can be drawn by the seller within the range of competitive

and monopoly demand curves.

Leaving aside retaliatory price movements, the individual seller’s demand

curve under oligopoly for both price cuts and increases is neither more

elastic than under perfect or monopolistic competition nor less elastic than

under monopoly. It may still be indefinite and indeterminate.

This situation is shown in Figure 1 Where KD1 is the elastic demand curve

and MD is the less elastic demand curve. The oligopolies’ demand curve is

the dotted kinked KPD. The reason is quite simple. If a seller reduces the

price of his product, his rivals also lower the prices of their products so that

he is not able to increase his sales.

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So the demand curve for the individual seller’s product will be less elastic

just below the present price P (where KD1and MD curves are shown to

intersect). On the other hand, when he raises the price of his product, the

other sellers will not follow him in order to earn larger profits at the old

price. So this individual seller will experience a sharp fall in the demand for

his product.

Thus his demand curve above the price P in the segment KP will be highly

elastic. Thus the imagined demand curve of an oligopolist has a comer or

kink at the current price P. Such a demand curve is much more elastic for

price increases than for price decreases.

(7) No Unique Pattern of Pricing Behaviour:

The rivalry arising from interdependence among the oligopolists leads to

two conflicting motives. Each wants to remain independent and to get the

maximum possible profit. Towards this end, they act and react on the price-

output movements of one another in a continuous element of uncertainty.

On the other hand, again motivated by profit maximisation each seller

wishes to cooperate with his rivals to reduce or eliminate the element of

uncertainty. All rivals enter into a tacit or formal agreement with regard to

price-output changes. It leads to a sort of monopoly within oligopoly.

They may even recognise one seller as a leader at whose initiative all the

other sellers raise or lower the price. In this case, the individual seller’s

demand curve is a part of the industry demand curve, having the elasticity

of the latter. Given these conflicting attitudes, it is not possible to predict

any unique pattern of pricing behaviour in oligopoly markets.

5. Monopolistic Competition:

Monopolistic competition refers to a market situation where there are

many firms selling a differentiated product. “There is competition which is

keen, though not perfect, among many firms making very similar

products.” No firm can have any perceptible influence on the price-output

21

policies of the other sellers nor can it be influenced much by their actions.

Thus monopolistic competition refers to competition among a large

number of sellers producing close but not perfect substitutes for each other.

It’s Features:

The following are the main features of monopolistic

competition:

(1) Large Number of Sellers:

In monopolistic competition the number of sellers is large. They are “many

and small enough” but none controls a major portion of the total output. No

seller by changing its price-output policy can have any perceptible effect on

the sales of others and in turn be influenced by them. Thus there is no

recognised interdependence of the price-output policies of the sellers and

each seller pursues an independent course of action.

(2) Product Differentiation:

One of the most important features of the monopolistic competition is

differentiation. Product differentiation implies that products are different

in some ways from each other. They are heterogeneous rather than

homogeneous so that each firm has an absolute monopoly in the

production and sale of a differentiated product. There is, however, slight

difference between one product and other in the same category.

Products are close substitutes with a high cross-elasticity and not perfect

substitutes. Product “differentiation may be based upon certain

characteristics of the products itself, such as exclusive patented features;

trade-marks; trade names; peculiarities of package or container, if any; or

singularity in quality, design, colour, or style. It may also exist with respect

to the conditions surrounding its sales.”

22

(3) Freedom of Entry and Exit of Firms:

Another feature of monopolistic competition is the freedom of entry and

exit of firms. As firms are of small size and are capable of producing close

substitutes, they can leave or enter the industry or group in the long run.

(4) Nature of Demand Curve:

Under monopolistic competition no single firm controls more than a small

portion of the total output of a product. No doubt there is an element of

differentiation nevertheless the products are close substitutes. As a result, a

reduction in its price will increase the sales of the firm but it will have little

effect on the price-output conditions of other firms, each will lose only a

few of its customers.

Likewise, an increase in its price will reduce its demand substantially but

each of its rivals will attract only a few of its customers. Therefore, the

demand curve (average revenue curve) of a firm under monopolistic

competition slopes downward to the right. It is elastic but not perfectly

elastic within a relevant range of prices of which he can sell any amount.

(5) Independent Behaviour:

In monopolistic competition, every firm has independent policy. Since the

number of sellers is large, none controls a major portion of the total output.

No seller by changing its price-output policy can have any perceptible effect

on the sales of others and in turn be influenced by them.

(6) Product Groups:

There is no any ‘industry’ under monopolistic competition but a ‘group’ of

firms producing similar products. Each firm produces a distinct product

and is itself an industry. Chamberlin lumps together firms producing very

closely related products and calls them product groups, such as cars,

cigarettes, etc.

23

(7) Selling Costs:

Under monopolistic competition where the product is differentiated, selling

costs are essential to push up the sales. Besides, advertisement, it includes

expenses on salesman, allowances to sellers for window displays, free

service, free sampling, premium coupons and gifts, etc.

(8) Non-price Competition:

Under monopolistic competition, a firm increases sales and profits of his

product without a cut in the price. The monopolistic competitor can change

his product either by varying its quality, packing, etc. or by changing

promotional programmes.

Market Type

Pure Competitio n

Monopol c

isti Oligopoly Pure Monopoly

Number firms

of Very large Many several

/ Few One

Type of product

Conditions of entry

Standardized / homogeneou s

e.g. graded grains, teas, crude oil, iron, etc.

Very easy, no obstacle; unrestricted entry

Differentiated

-many brand names

e.g. shoes, dresses, restaurants

Relatively easy

Standardized (to some extent steel & petroleum) or differentiated (e.g. electrical appliances, cars, etc. )

Restricted

(by copyrights, control over natural resources, heavy

Unique

e.g. Sole copyright holder or local utility provider.

Restricted or completely blocked.

24

Control over price

None, price taker; Consumer Sovereignty

Some but with rather narrow limits

overhead investment, etc.)

Considerable with collusion (OPEC)

Considerabl e, price maker. (complete control over output); Producer Sovereignty.

Non-price competitio n

Shape of Demand Curve for firm

None Advertising, brand names, etc.

Horizontal. Downward

sloping but relatively elastic.

A great deal with high degree of product differentiatio n

Downward sloping & relatively inelastic but depends on reactions from rivals to a price change.

Mostly public relation advertising.

Downward sloping & more inelastic compared to those for Oligopoly.

25

NATIONAL INCOME

National income estimates are the most reliable macroeconomic indicators

of an economy. Therefore, it is essential for students to be aware of

National Income Concepts. Changes in national income measure the rate of

growth of the economy.

Similarly, changes in the structure of national income of an economy reflect

the changing significance of different sectors. In India, national income, as

also per capita income, have been continuously increasing. In more recent

years, the rate of growth of national income has accelerated. It indicates

that the economy has been growing at a faster rate in recent years than in

the past. Along with this, the structure of national income has also

undergone a change, the tertiary sector has emerged as the dominant sector

of the economy.

The task of preparing national income estimates has been assigned to the

Central Statistical Organisation (CSO). The CSO has been producing annual

official estimates of national income of India since 1955 and publishing the

same in its annual report National Accounts Statistics.

Concept of National Income

National income accounting comprises of four concepts of calculations-

GDP, NDP, GNP, NNP.

1. Factor cost is the input cost that producer has to incur in the process

of production. It includes cost of capital – loan inetrest, prices of raw

materials, labour, power, rent, etc. Can be termed as Production cost.

2. Market cost is calculated after adding indirect taxes to the factor cost

of the product. It is basically the cost at which the goods reach the

market. Also termed as EX-FACTORY PRICE. In India we calculate

income at factor cost because of non-uniform taxes.

National Income: The sum total of factor of incomes accruing to the

residents of the country, both from their activities within and outside the

economic territory is the national income of the country.

National income is calculated for a particular period, normally a financial year (In India, financial year means April 1 to March 31 of next year). Net

26

factor income from abroad is added to the domestic product to get the value

of National Income.GDP calculation showing circular flow

National Income = C + I + G + (X – M)

Where, C = Total consumption expenditure

I = Total investment expenditure

G = Total government expenditure ;

X – M = Export – Import

The National Income concepts include the following important terms:

Gross Domestic Product (GDP)

Gross domestic product is the value of all final goods and services produced

within the boundary of a nation during one year. In India one year means

from 1St April to 31St March of the next year.

GDP calculation includes income of foreigners in a Country but excludes

income of those people who are living outside of that country.

Net Domestic Product (NDP)

NDP is calculated by deducting the depreciation of plant and Machinery

from GDP.

NDP = Gross Domestic Product – Depreciation

Gross National Product (GNP)

GNP is the value of all final goods and services produced by the residents of

a country in a financial year (i.e., 1St April to 31St March of the next year in

India).

While Calculating GNP, income of foreigners in a country is excluded but

income of people who are living outside of that country is included. It is the

GDP of a country added with its income from abroad.

27

GNP = GDP + X – M

Where, X = income of the people of a country who are living outside of the Country and M = income of the foreigners in a country

India’s GNP is always lower than its GDP.

This is the national income according to which the IMF ranks nations.

1. It allows for knowledge of factors in production behaviour and

pattern of an economy’s dependence on outside world, nature of

human resources internationally, position in world economics.

2. It indicates both qualitative as well as quantitative aspects of an

economy in a more exhaustive fashion than GDP.

Intermediate products = one production unit purchasing from other for

resale

Final product = all goods and services purchased for consumption and

investment , and not for resale

Value added = Value of output – Intermediate cost

Gross value added = net value added + depreciation

Indirect tax = all taxes levied on production, finally paid by consumer of

buyer Ex – sales tax, excise, customs

Subsidies = Financial help given by the government to the production units

for selling the product at lower prices

Net National Product (NNP)

Net National Product (NNP) in an economy is the GNP after deducting the loss due to depreciation.

NNP = GNP – Depreciation

NNP at Factor Cost: It is the value of NNP when the value of goods and

services is taken at the production cost.

NNP at Market Price: It is the value of NNP at consumer cost.

28

NNP at market cost = NNP at factor cost + Indirect taxes – Subsidies

Closed Economy: An economy that does not maintain any economic

relations with the rest of the world. Economic Goods: Those goods which

are scarce in supply and, hence, command a price.

Economic Growth: A sustained increase in real national income of a

country.

Nominal National Income: The money value of all the final goods and

services produced in an economy during a year, estimated at current prices.

Real National Income: The money value of all the final goods and

services produced in an economy during a year, estimated at some fixed

prices.

Subsidy: It is the grant given on current account by the Government to the

private industries and public corporations for selling certain goods at a

price fixed by the Government.

NATIONAL INCOME MEASUREMENT:

Primary sector: all production units engaged in exploitation of natural resources like Agriculture, Fishing, Mining and Quarrying , Forestry and

Logging

Secondary sector: all production units engaged in transforming one

good to another like Registered manufacture, unregistered, Construction,

Electricity Gas Water supply

Tertiary sector: all units engaged in producing services like

Banking&Insurance, Trade, hotel, restaurant, transport, storage , Real

estate dwelling, Public administration & defence, other services.

29

THE CLASSICAL THEORY OF EMPLOYMENT: ASSUMPTION AND CRITICISM

Introduction:

John Maynard Keynes in his General Theory of Employment, Interest

and Money published in 1936, made a frontal attack on the classical

postulates. He developed a new economics which brought about a

revolution in economic thought and policy.

The General Theory was written against the background of classical

thought. By the “classicists” Keynes meant “the followers of Ricardo, those,

that is to say, who adopted and perfected the theory of Ricardian

economics.” They included, in particular, J.S. Mill, Marshall and Pigou.

Keynes repudiated traditional and orthodox economics which had been

built up over a century and which dominated economic thought and policy

before and during the Great Depression. Since the Keynesian Economics is

based on the criticism of classical economics, it is necessary to know the

latter as embodied in the theory of employment

1. The Classical Theory of Employment:

The classical economists believed in the existence of full employment in the

economy. To them, full employment was a normal situation and any

deviation from this regarded as something abnormal. According to Pigou,

the tendency of the economic system is to automatically provide full

employment in the labour market when the demand and supply of labour

are equal.

Unemployment results from the rigidity in the wage structure and

interference in the working of free market system in the form of trade union

legislation, minimum wage legislation etc. Full employment exists “when

everybody who at the running rate of wages wishes to be employed.”

Those who are not prepared to work at the existing wage rate are not

unemployed because they are voluntarily unemployed. Thus full

employment is a situation where there is no possibility of involuntary

30

unemployment in the sense that people are prepared to work at the current

wage rate but they do not find work.

The basis of the classical theory is Say’s Law of Markets which was carried

forward by classical economists like Marshall and Pigou. They explained

the determination of output and employment divided into individual

markets for labour, goods and money. Each market involves a built-in

equilibrium mechanism to ensure full employment in the economy.

It’s Assumptions:

The classical theory of output and employment is based on the

following assumptions:

1. There is the existence of full employment without inflation.

2. There is a laissez-faire capitalist economy without government

interference.

3. It is a closed economy without foreign trade.

4. There is perfect competition in labour and product markets.

5. Labour is homogeneous.

6. Total output of the economy is divided between consumption and

investment expenditures.

7. The quantity of money is given and money is only the medium of

exchange.

8. Wages and prices are perfectly flexible.

9. There is perfect information on the part of all market participants.

10. Money wages and real wages are directly related and

proportional.

31

11. Savings are automatically invested and equality between the two is

brought about by the rate of interest

12. Capital stock and technical knowledge are given.

13.The law of diminishing returns operates in production.

14.It assumes long run.

It’s Explanation:

The determination of output and employment in the classical theory occurs

in labour, goods and money markets in the economy.

Say’s Law of Markets:

Say’s law of markets is the core of the classical theory of employment. An

early 19th century French Economist, J.B. Say, enunciated the proposition

that “supply creates its own demand.” Therefore, there cannot be general

overproduction and the problem of unemployment in the economy.

If there is general overproduction in the economy, then some labourers

may be asked to leave their jobs. The problem of unemployment arises in

the economy in the short run. In the long run, the economy will

automatically tend toward full employment when the demand and supply of

goods become equal.

When a producer produces goods and pays wages to workers, the workers,

in turn, buy those goods in the market. Thus the very act of supplying

(producing) goods implies a demand for them. It is in this way that supply

creates its own demand.

Determination of Output and Employment:

In the classical theory, output and employment are determined by the

production function and the demand for labour and the supply of labour in

the economy. Given the capital stock, technical knowledge and other

factors, a precise relation exists between total output and amount of

32

employment, i.e., number of workers. This is shown in the form of the

following production function: Q=f (K, T, N)

where total output (Q) is a function (f) of capital stock (K), technical

knowledge (T), and the number of workers (N)

Given K and T, the production function becomes Q = f (AO which shows

that output is a function of the number of workers. Output is an increasing

function of the number of workers, output increases as the employment of

labour rises. But after a point when more workers are employed,

diminishing marginal returns to labour start.

This is shown in Fig. 1 Where the curve Q = f (N) is the production function

and the total output OQ1 corresponds to the full employment level NF. But

when more workers NfN2 are employed beyond the full employment level of

output OQ1, the increase in output Q1Q2 is less than the increase in

employment N1N2.

Labour Market Equilibrium:

In the labour market, the demand for labour and the supply of labour

determine the level of output and employment. The classical economists

regard the demand for labour as the function of the real wage rate: DN =f

(W/P)

Where DN = demand for labour, W = wage rate and P = price level. Dividing

wage rate (W) by price level (P), we get the real wage rate (W/P).

The demand for labour is a decreasing function of the real wage rate, as

shown by the downward sloping DN curve in Fig. 2. It is by reducing the real

wage rate that more workers can be employed.

33

The supply of labour also depends on the real wage rate: SN =f (W/P), where

SN is the supply of labour. But it is an increasing function of the real wage

rate, as shown by the upward sloping SN curve in Fig. 2. It is by increasing

the real wage rate that more workers can be employed.

When the DN and SN curves intersect at point E, the full employment level

NF is determined at the equilibrium real wage rate W/P0. If the wage rate

rises from WP0 to WP1 the supply of labour will be more than its demand by

ds.

Now at W/P1 wage rate, ds workers will be involuntary unemployed because

the demand for labour (W/P1-d) is less than their supply (W/P1-s). With

competition among workers for work, they will be willing to accept a lower

wage rate. Consequently, the wage rate will fall from W/P1 to W/P0.

The supply of labour will fall and the demand for labour will rise and the

equilibrium point E will be restored along with the full employment level

Nr On the contrary, if the wage rate falls from W/P0 to WP2 the demand for

labour (W/P2-d1) will be more than its supply (W/P2-s1). Competition by

employers for workers will raise the wage rate from W/ P2 to W/P0 and the

equilibrium point E will be restored along with the full employment level

NF.

Wage Price Flexibility:

The classical economists believed that there was always full employment in

the economy. In case of unemployment, a general cut in money wages

34

would take the economy to the full employment level. This argument is

based on the assumption that there is a direct and proportional relation

between money wages and real wages.

When money wages are reduced, they lead to reduction in cost of

production and consequently to the lower prices of products. When prices

fall, demand for products will increase and sales will be pushed up.

Increased sales will necessitate the employment of more labour and

ultimately full employment will be attained.

Pigou explains the entire proposition in the equation: N = qY/W. In this

equation, N is the number of workers employed, q is the fraction of income

earned as wages, Y is the national income and W is the money wage rate. N

can be increased by a reduction in W. Thus the key to full employment is a

reduction in money wage. When prices fall with the reduction of money

wage, real wage is also reduced in the same proportion.

As explained above, the demand for labour is a decreasing function of the

real wage rate. If W is the money wage rate, P is the price of the product,

and MPN is the marginal product of labour, we have W=P X MPN or W/P =

MPN

Since MPN declines as employment increases, it follows that the level of

employment increases as the real wage (W/P) declines. This is explained in

Figure 3. In Panel (A), SN is the supply curve of labour and DN is the

demand curve for labour. The intersection of the two curves at E shows the

level of full employment NF and the real wage W/P0.

If the real wage rises to W/P1, supply exceeds the demand for labour by sd

and N1N2 workers are unemployed. It is only when the wage is reduced to

W/P0 that unemployment disappears and the level of full employment is

attained.

35

This is shown in Panel (B), where MPN is the marginal product of labour

curve which slopes downward as more labour is employed. Since every

worker is paid wages equal to his marginal product, therefore the full

employment level NF is reached when the wage rate falls from W/P1 to

W/P0.

Contrariwise, with the fall in the wage from W/P0 to W/P2, the demand for

labour increases more than its supply by s1d1, the workers demand higher

wage. This leads to the rise in the wage from W/P2 to W/P0 and the full

employment level NF is attained

Goods Market Equilibrium:

The goods market is in equilibrium when saving equals investment. At that

point of time, total demand equals total supply and the economy is in a

state of full employment. According to the classicists, what is not spent is

automatically invested.

Thus saving must equal investment. If there is any divergence between the

two, the equality is maintained through the mechanism of the rate of

interest. To them, both saving and investment are the functions of the

interest rate.

36

S=f(r) …(1)

I=f(r) …(2)

S = I

Where S = saving, I = investment, and r = interest rate.

To the classicists, interest is a reward for saving. The higher the rate of

interest, the higher the saving, and lower the investment. On the contrary,

the lower the rate of interest, the higher the demand for investment funds,

and lowers the saving. If at any given period, investment exceeds saving, (I

> S) the rate of interest will rise.

Saving will increase and investment will decline till the two are equal at the

full employment level. This is because saving is regarded as an increasing

function of the interest rate and investment as a decreasing function of the

rate of interest.

Assuming interest rates are perfectly elastic, the mechanism of the equality

between saving and investment is shown in Figure 4 where S is the saving

curve and I is the investment curve. Both intersect at E which is the full

employment level where at Or interest rate S = I. If the interest rate rises to

Or1 saving is more than investment by ha which will lead to unemployment

in the economy.

Since S > I, the investment demand for capital being less than its supply,

the interest rate will fall to Or, investment will increase and saving will

decline. Consequently, S = I equilibrium will be re-established at point E.

37

On the contrary, with a fall in the interest rate from Or to Or2 investment

will be more than saving (I > S) by cd, the demand for capital will be more

than its supply. The interest rate will rise, saving will increase and

investment will decline. Ultimately, S = I equilibrium will be restored at the

full employment level E.

Money Market Equilibrium:

The money market equilibrium in the classical theory is based on the

Quantity Theory of Money which states that the general price level (P) in

the economy depends on the supply of money (M). The equation is MV=

PT, where M = supply of money, V= velocity of circulation of M, P = Price

level, and T = volume of transaction or total output.

The equation tells that the total money supply MV equals the total value of

output PT in the economy. Assuming V and T to be constant, a change in

the supply of money (M) causes a proportional change in the price level (P).

Thus the price level is a function of the money supply: P = f (M).

The relation between quantity of money, total output and price level is

depicted in Figure 5 where the price level is taken on the horizontal axis

and the total output on the vertical axis. MV is the/money supply curve

which is a rectangular hyperbola.

This is because the equation MV = PT holds on all points of this curve.

Given the output level OQ, there would be only one price level OP

consistent with the quantity of money, as shown by point M on the MV

curve. If the quantity of money increases, the MV curve will shift to the

right as M1V curve.

38

As a result, the price level would rise from OP to OP1 given the same level of

output OQ. This rise in the price level is exactly proportional to the rise in

the quantity of money, i.e., PP1 = MM1 when the full employment level of

output remains OQ.

2. Complete Classical Model – A Summary:

The classical theory of employment was based on the assumption of full

employment where full employment was a normal situation and any

deviation from this was regarded as an abnormal situation. This was based

on Say’s Law of Market.

According to this, supply creates its own demand and the problem of

overproduction and unemployment does not arise. Thus there is always full

employment in the economy. If there is overproduction and

unemployment, the automatic forces of demand and supply in the market

will bring back the full employment level.

In the classical theory, the determination of output and employment takes

place in labour, goods and money markets of the economy, as shown in Fig.

6. The forces of demand and supply in these markets will ultimately bring

full employment in the economy.

39

In the classical analysis, output and employment in the economy are

determined by the aggregate production function, demand for labour and

supply of labour. Given the stock of capital, technical knowledge and other

factors, there is a precise relation between total output and employment

(number of workers).

This is expressed as Q = f (K, T, N). In other words, total output (Q) is a

function (f) of capital stock (K), technical knowledge T, and number of

workers (TV). Given K and T, total output (Q) is an increasing function of

the number of workers (N): Q=f (N) as shown in Panel (B). At point E,

ONF workers produce OQ output. But beyond point E, as more workers are

employed, diminishing marginal returns start.

Labour Market Equilibrium:

In the labour market, the demand for and supply of labour determine

output and employment in the economy. The demand for labour depends

40

on total output. As production increases, the demand for labour also

increases.

The demand for labour, in turn, depends on the marginal productivity (MP)

of labour which declines as more workers are employed. The supply of

labour depends on the wage rate, SL = f (W/P), and is an increasing

function of the wage rate.

The demand for labour also depends on the wage rate, DL =f (W/P), and is a

decreasing function of the wage rate. Thus both the demand for and supply

of labour are the functions of real wage rate (W/P). The intersection point E

of DL and SL curves at W/ P wage rate in Panel (C) of the figure determines

the full employment level ONF.

Goods Market Equilibrium:

In the classical analysis, the goods market is in equilibrium when saving

and investment are in equilibrium (S=I). This equality is brought about by

the mechanism of interest rate at the full employment level of output so

that the quantity of goods demanded is equal to the quantity of goods

supplied. This is shown in Panel (A) of the figure where S=I at point E when

the interest rate is Or.

Money Market Equilibrium:

The money market is in equilibrium when the demand for money equals

the supply of money. This is explained by the Quantity Theory of Money

which states that the quantity of money is a function of the price level, P=f

(MV). Changes in the general price level are proportional to the quantity of

money.

The equilibrium in the money market is shown by the equation MV = PT

where MV is the supply of money and PT is the demand for money. The

equilibrium of the money market explains the price level corresponding to

the full employment level of output which relates Panel (E) and Panel (B)

with MQ line.

41

The price level OP is determined by total output (Q) and the quantity of

money (MV), as shown in Panel (E). Then the real wage corresponding with

the money wage is determined by the (W/P) curve, as shown in Panel (D).

When the money wage increases, the real wage also increases in the same

proportion and there is no effect on the level of output and employment. It

follows that the money wage should be reduced in order to attain the full

employment level in the economy. Thus the classicists favoured a flexible

price-wage policy to maintain full employment.

3. Keynes’s Criticism of Classical Theory:

Keynes vehemently criticised the classical theory of employment for its

unrealistic assumptions in his General Theory.

He attacked the classical theory on the following counts:

(1) Underemployment Equilibrium:

Keynes rejected the fundamental classical assumption of full employment

equilibrium in the economy. He considered it as unrealistic. He regarded

full employment as a special situation. The general situation in a capitalist

economy is one of underemployment.

This is because the capitalist society does not function according to Say’s

law, and supply always exceeds its demand. We find millions of workers are

prepared to work at the current wage rate, and even below it, but they do

not find work.

Thus the existence of involuntary unemployment in capitalist economies

(entirely ruled out by the classicists) proves that underemployment

equilibrium is a normal situation and full employment equilibrium is

abnormal and accidental.

(2) Refutation of Say’s Law:

Keynes refuted Say’s Law of markets that supply always created its own

demand. He maintained that all income earned by the factor owners would

not be spent in buying products which they helped to produce.

42

A part of the earned income is saved and is not automatically invested

because saving and investment are distinct functions. So when all earned

income is not spent on consumption goods and a portion of it is saved,

there results in a deficiency of aggregate demand.

This leads to general overproduction because all that is produced is not

sold. This, in turn, leads to general unemployment. Thus Keynes rejected

Say’s Law that supply created its own demand. Instead he argued that it

was demand that created supply. When aggregate demand rises, to meet

that demand, firms produce more and employ more people.

(3) Self-adjustment not Possible:

Keynes did not agree with the classical view that the laissez-faire policy was

essential for an automatic and self-adjusting process of full employment

equilibrium. He pointed out that the capitalist system was not automatic

and self-adjusting because of the non-egalitarian structure of its society.

There are two principal classes, the rich and the poor.

The rich possess much wealth but they do not spend the whole of it on

consumption. The poor lack money to purchase consumption goods. Thus

there is general deficiency of aggregate demand in relation to aggregate

supply which leads to overproduction and unemployment in the economy.

This, in fact, led to the Great Depression.

Had the capitalist system been automatic and self-adjusting, this would not

have occurred. Keynes, therefore, advocated state intervention for adjusting

supply and demand within the economy through fiscal and monetary

measures.

(4) Equality of Saving and Investment through Income

Changes:

The classicists believed that saving and investment were equal at the full

employment level and in case of any divergence the equality was brought

about by the mechanism of rate of interest. Keynes held that the level of

saving depended upon the level of income and not on the rate of interest.

43

Similarly investment is determined not only by rate of interest but by the

marginal efficiency of capital. A low rate of interest cannot increase

investment if business expectations are low. If saving exceeds investment, it

means people are spending less on consumption.

As a result, demand declines. There is overproduction and fall in

investment, income, employment and output. It will lead to reduction in

saving and ultimately the equality between saving and investment will be

attained at a lower level of income. Thus it is variations in income rather

than in interest rate that bring the equality between saving and investment.

(5) Importance of Speculative Demand for Money:

The classical economists believed that money was demanded for

transactions and precautionary purposes. They did not recognise the

speculative demand for money because money held for speculative

purposes related to idle balances.

But Keynes did not agree with this view. He emphasised the importance of

speculative demand for money. He pointed out that the earning of interest

from assets meant for transactions and precautionary purposes may be very

small at a low rate of interest.

But the speculative demand for money would be infinitely large at a low

rate of interest. Thus the rate of interest will not fall below a certain

minimum level, and the speculative demand for money would become

perfectly interest elastic. This is Keynes ‘liquidity trap’ which the classicists

failed to analyse.

(6) Rejection of Quantity Theory of Money:

Keynes rejected the classical Quantity Theory of Money on the ground that

increase in money supply will not necessarily lead to rise in prices. It is not

essential that people may spend all extra money. They may deposit it in the

bank or save.

So the velocity of circulation of money (V) may slow down and not remain

constant. Thus V in the equation MV = PT may vary. Moreover, an increase

44

in money supply, may lead to increase in investment, employment and

output if there are idle resources in the economy and the price level (P) may

not be affected.

(7) Money not Neutral:

The classical economists regarded money as neutral. Therefore, they

excluded the theory of output, employment and interest rate from

monetary theory. According to them, the level of output and employment

and the equilibrium rate of interest were determined by real forces.

Keynes criticised the classical view that monetary theory was separate from

value theory. He integrated monetary theory with value theory, and brought

the theory of interest in the domain of monetary theory by regarding the

interest rate as a monetary phenomenon. He integrated the value theory

and the monetary theory through the theory of output.

This he did by forging a link between the quantity of money and the price

level via the rate of interest. For instance, when the quantity of money

increases, the rate of interest falls, investment increases, income and output

increase, demand increases, factor costs and wages increase, relative prices

increase, and ultimately the general price level rises. Thus Keynes

integrated monetary and real sectors of the economy.

(8) Refutation of Wage-Cut:

Keynes refuted the Pigovian formulation that a cut in money wage could

achieve full employment in the economy. The greatest fallacy in Pigou’s

analysis was that he extended the argument to the economy which was

applicable to a particular industry.

Reduction in wage rate can increase employment in an industry by

reducing costs and increasing demand. But the adoption of such a policy for

the economy leads to a reduction in employment. When there is a general

wage-cut, the income of the workers is reduced. As a result, aggregate

demand falls leading to a decline in employment.

45

From the practical view point also Keynes never favoured a wage cut policy.

In modern times, workers have formed strong trade unions which resist a

cut in money wage. They would resort to strikes. The consequent unrest in

the economy would bring a decline in output and income. Moreover, social

justice demands that wages should not be cut if profits are left untouched.

(9) No Direct and Proportionate Relation between Money and

Real Wages:

Keynes also did not accept the classical view that there was a direct and

proportionate relationship between money wages and real wages.

According to him, there is an inverse relation between the two. When

money wages fall, real wages rise and vice versa.

Therefore, a reduction in the money wage would not reduce the real wage,

as the classicists believed, rather it would increase it. This is because the

money wage cut will reduce cost of production and prices by more than the

former.

Thus the classical view that fall in real wages will increase employment

breaks down. Keynes, however, believed that employment could be

increased more easily through monetary and fiscal measures rather than by

reduction in money wage. Moreover, institutional resistances to wage and

price reductions are so strong that it is not possible to implement such a

policy administratively.

(10) State Intervention Essential:

Keynes did not agree with Pigou that “frictional maladjustments alone

account for failure to utilise fully our productive power.” The capitalist

system is such that left to itself it is incapable of using productive

powerfully. Therefore, state intervention is necessary.

The state may directly invest to raise the level of economic activity or to

supplement private investment. It may pass legislation recognising trade

unions, fixing minimum wages and providing relief to workers through

social security measures.

46

“Therefore”, as observed by Dillard, “it is bad politics even if it should be

considered good economics to object to labour unions and to liberal labour

legislation.” So Keynes favoured state action to utilise fully the resources of

the economy for attaining full employment.

(11) Long-Run Analysis Unrealistic:

The classicists believed in the long-run full employment equilibrium

through a self-adjusting process. Keynes had no patience to wait for the

long period for he believed that “In the long-run we are all dead”.

As pointed by Schumpeter, “His philosophy of life was essentially a short-

term philosophy.” His analysis is confined to short-run phenomena. Unlike

the classicists, he assumes tastes, habits, techniques of production, supply

of labour, etc. to be constant during the short period and so neglects long-

run influences on demand.

Assuming consumption demand to be constant, he lays emphasis on

increasing investment to remove unemployment. But the equilibrium level

so reached is one of underemployment rather than of full employment.

Thus the classical theory of employment is unrealistic and is incapable of

solving the present day economic problems of the capitalist world.

47

THE KEYNESIAN THEORY OF INCOME, OUTPUT AND EMPLOYMENT

In the Keynesian theory, employment depends upon effective

demand. Effective demand results in output. Output creates income.

Income provides employment. Since Keynes assumes all these four

quantities, viz., effective demand (ED), output (Q), income (Y) and

employment (N) equal to each other, he regards employment as a function

of income.

Effective demand is determined by two factors, the aggregate supply

function and the aggregate demand function. The aggregate supply function

depends on physical or technical conditions of production which do not

change in the short-run.

Since Keynes assumes the aggregate supply function to be stable, he

concentrates his entire attention upon the aggregate demand function to

fight depression and unemployment. Thus employment depends on

aggregate demand which in turn is determined by consumption demand

and investment demand.

According to Keynes, employment can be increased by increasing

consumption and/or investment. Consumption depends on income C(Y)

and when income rises, consumption also rises but not as much as income.

In other words, as income rises, saving rises.

Consumption can be increased by raising the propensity to consume in

order to increase income and employment. But the propensity to consume

depends upon the psychology of the people, their tastes, habits, wants and

the social structure which determine the distribution of income.

All these elements remain constant during the short-run. Therefore, the

propensity to consume is stable. Employment thus depends on investment

and it varies in the same direction as the volume of investment.

Investment, in turn, depends on the rate of interest and the marginal

efficiency of capital (MEC). Investment can be increased by a fall in the rate

48

of interest and/or a rise in the MEC. The MEC depends on the supply price

of capital assets and their prospective yield.

It can be raised when the supply price of capital assets falls or their

prospective yield increases. Since the supply price of capital assets is stable

in the short- run, it is difficult to lower it. The second determinant of MEC

is the prospective yield of capital assets which depends on the expectations

of yields on the part of businessmen. It is again a psychological factor which

cannot be depended upon to increase the MEC to raise investment. Thus

there is little scope for increasing investment by raising the MEC.

The other determinant of investment is the rate of interest. Investment and

employment can be increased by lowering the rate of interest. The rate of

interest is determined by the demand for money and the supply of money.

On the demand side is the liquidity preference (LP) schedule.

The higher the liquidity preference, the higher is the rate of interest that

will have to be paid to cash holders to induce them to part with their liquid

assets, and vice versa. People hold money (M) in cash for three motives:

transactions, precautionary and speculative.

The transactions and precautionary motives (M) are income elastic. Thus

the amount held under these two motives (M1) is a function (L1) of the level

of income (Y), i.e. M=L (Y). But the money held for speculative motive (M2)

is a function of the rate of interest (r), i.e. M=L2 (r). The higher the rate of

interest, the lower the demand for money, and vice versa.

Since LP depends on the psychological attitude to liquidity on the part of

speculators with regard to future interest rates, it is not possible to lower

the liquidity preference in order to bring down the rate of interest. The

other determinant of interest rate is the supply of money which is assumed

to be fixed by the monetary authority during the short-run.

The relation between interest rate, MEC and investment is shown in Figure

1, where in Panels (A) and (B) the total demand for money is measured

along the horizontal axis from M onward. The transactions (and

49

precautionary) demand is given by the L1 curve at OY1 and OY2 levels of

income in Panel (A) of the figure.

:

Thus at OY1 income level, the transactions demand is given by OM1 and at

OY2 level of income it is OM2. In Panel (B), the L2 curve represents the

speculative demand for money as a function of the rate of interest.

When the rate of interest is R2, the speculative demand for money is MM2.

With the fall in the rate of interest to R1, the speculative demand for money

increases to MM1. Panel (C) shows investment as a function of the rate of

interest and the MEC. Given the MEC, when the rate of interest is R2, the

level of investment is OI1. But when the rate of interest falls to R1,

investment increases to OI2.

“In the Keynesian analysis, the equilibrium level of employment and

income is determined at the point of equality between saving and

investment. Saving is a function of income, i.e. S=f (Y). It is defined as the

excess of income over consumption, S=Y-C and income is equal to

consumption plus investment.

Thus Y = C + I Or Y-C = I

50

Y-C = S

I = S

So the equilibrium level of income is established where saving equals

investment. This is shown in Panel (D) of Figure 1 Where the horizontal axis

from O toward the right represents investment and saving, and OY axis

represents income. S is the saving curve.

The line I1E1 is the investment curve (imagine that it can be extended

beyond E as in an S and I diagram) which touches the S curve at E1. Thus

OY1 is the equilibrium level of employment and income. This is the level of

underemployment equilibrium, according to Keynes. If OY2 is assumed to

be the full employment level of income then the equality between saving

and investment will take place at E2 where I2E2 investment equals

Y2E2 saving.

The Keynesian theory of employment and income is also explained in terms

of the equality of aggregate supply (C+S) and aggregate demand (C+I).

Since unemployment results from the deficiency of aggregate demand,

employment and income can be increased by increasing aggregate demand.

Assuming the propensity to consume to be stable during the short-run,

aggregate demand can be increased by increasing investment. Once

investment increases, employment and income increase. Increased income

leads to a rise in the demand for consumption goods which leads to further

increase in employment and income.

Once set in motion, employment and income tend to rise in a cumulative

manner through the multiplier process till they reach the equilibrium level.

According to Keynes, the equilibrium level of employment will be one of

under-employment equilibrium because when income increases

consumption also increases but by less than the increase in income.

This behaviour of the consumption function widens the gap between

income and consumption which ordinarily cannot by filled up due to the

lack of required investment. The full employment income level can only be

51

established if the volume of investment is increased to fill the income-

consumption gap corresponding to full employment.

The Keynesian cross model of under-employment equilibrium is explained

in Figure 2 Where income and employment are taken on the horizontal axis

and consumption and investment on the vertical axis. Autonomous

investment is taken as a first approximation. C+I is the aggregate demand

curve plotted by adding to consumption function C an equal amount of

investment at all levels of income.

The 45° line is the aggregate supply curve. The economy is in equilibrium at

point E where the aggregate demand curves C+I intersects the 45° line. This

is the point of effective demand where the equilibrium level of income and

employment OY1 is determined.

This is the level of underemployment equilibrium and not of full

employment. There are no automatic forces that can make the two curves

cross at a full employment income level. If it happens to be a full

employment level, it will be accidental. Keynes regarded the under-

employment equilibrium level as a normal case and the full employment

income level as a special case.

Suppose OYF is the full employment income level. To reach this level,

autonomous investment is increased by I1 so that the C+I curve shifts

upward as C+I+I1, curve. This is the new aggregate demand curve which

52

intersects the 45° line (the aggregate supply curve) at E1, the higher point of

effective demand corresponding to the full employment income level OYF.

This also reveals that to get a desired increase in employment and income

of Y1YF, it is the multiplier effect of an increase in investment by I1 (=I2 in

Panel C of Figure 1) which leads to an increase in employment and income

by Y1YF through successive rounds of investment.

53

CONSUMPTION FUNCTION

The consumption function or propensity to consume refers to income

consumption relationship. It is a “functional relationship between two

aggregates, i.e., total consumption and gross national income.”

Symbolically, the relationship is represented as C= f(Y), where С is consumption, Y is income, and/is the functional relationship. Thus the

consumption function indicates a functional relationship between С and Y,

where С is the depend at and Y is the independent variable, i.e., С is

determined by Y. This relationship is based on the ceteris paribus (other

things being equal) assumption, as such only income consumption

relationship is considered and all possible influences on consumption are

held constant.

In fact, propensity to consume or consumption function is a schedule of the

various amounts of consumption expenditure corresponding to different

levels of income. A hypothetical consumption schedule is given in Table 1.

Table 1 shows that consumption is an increasing function of income

because consumption ex-penditure increases with increase in income. Here

it is shown that when income is zero during the depression, people spend

out of their past savings on consumption because they must eat in order to

live.

When income is generated in the economy to the extent of Rs 60 crores, it

is not sufficient to meet the consumption expenditure of the community so

that the consumption expenditure of Rs 70 crores is still above the income

amounting to Rs 60 crores (Rs 10 crores are dissaved). When both

consumption expenditure and income equal Rs 120 crores, it is the basic

consumption level. After this, income is shown to increase by 60 crores and

consumption by 50 crores. This implies a stable consumption function

during the short-run as assumed by Keynes. Figure 1 illustrates the

consumption function diagrammatically.

54

In the diagram, income is measured horizontally and consumption is

measured verti-cally. 45° is the unity line where at all levels income and

consumption are equal. The С curve is a linear consumption function based

on the assumption that consumption changes by the same amount (Rs 50

crores).

Its upward slope to the right indicates that con-sumption is an increasing

function of income. В is the break-even point where C=Y or OY1 = OC1

When income rises to 0Y1 con-sumption also increases to 0C2, but the

increase in consumption is less than the increase in income, C1C2< Y1Y2

The portion of in-come not consumed is saved as shown by the vertical

distance between 45° line and С curve, i.e., SS’.

“Thus the consumption function measures not only the amount spent on

consumption but also the amount saved. This is because the propensity to

55

save is merely the propensity not to consume. The 45° line may therefore be

regarded as a zero-saving line, and the shape and position of the С curve

indicate the division of income between consumption and saving.”

2. Properties or Technical Attributes of the Consumption

Function:

The consumption function has two technical attributes or properties:

(i) The average propensity to consume, and

(ii) The marginal propensity to consume.

(1) The Average Propensity to Consume:

“The average propensity to consume may be defined as the ratio of

consumption expenditure to any particular level of income.” It is found by

dividing consumption expenditure by income, or APC = C/Y. It is expressed

as the percentage or proportion of income consumed. The APC at various

income levels is shown in column 3 of Table 2. The APC declines as income

increases because the proportion of income spent on consumption

decreases.

But reverse is the case with APS (average propen-sity to save) which

increases with increase in income (see column 4). Thus the APC also tells us

about the APS, APS=1-APC.

Diagrammatically, the average propensity to consume is any one point on

the С curve. In Figure 2 Panel (A), point R measures the APC of the С curve

which is OC’/OY’. The flattening of the С curve to the right shows declining

APC.

56

(2) The Marginal Propensity to Consume:

“The marginal propensity to consume may be de- fined as the ratio of the change in consumption to the change in income or as the rate of change

in the average propensity to consume as income changes.” It can be found

by dividing change in consump-tion by a change in income, or MPC —

clip_image008C/clip_image008[1]Y. The MPC is constant at all levels of

income as shown in column 5 of Table 2.

It is 0.83 or 83 per cent because the ratio of change in consumption to

change in income is clip_image008[2]C/clip_image008[3]Y = 50/60. The

marginal propensity to save can be derived from the MPC by the formula 1 -

MPC. It is 0.17 in our example (see column 6).

Diagrammatically, the marginal propensity to consume is measured by the

gradient or slope of the С curve. This is shown in Figure 2 Panel (B) by

NQ/RQ where NQ is change in consumption) and RQ is change in income (

Significance of MPC:

The MPC is the rate of change in the APC. When income increases, the MPC

falls but more than the APC. Contrariwise, when income falls, the MPC

rises and the APC also rises but at a slower rate than the former. Such

57

changes are only possible during cyclical fluctuations whereas in the short-

run there is change in the MPC and MPC<APC.

Keynes is concerned primarily with the MPC, for his analysis pertains to the

short-run while the APC is useful in the long-run analysis. The post-

Keynesian economists have come to the conclusion that over the long-run

APC and MPC are equal and approximate 0.9. In the Keynesian analysis the

MPC is given more prominence.

Its value is assumed to be positive and less than unity which means that

when income increases the whole of it is not spent on consumption. On the

contrary, when income falls, consumption expenditure does not decline in

the same proportion and never becomes zero.

For it is implied that the gap between income and consumption at all high levels of income is too wide to be easily filled by investment with the

possible consequence that the economy may fluctuate around

underemployment equilib-rium.” Thus the economic significance of the

MPC lies in filling the gap between income and consump-tion through

planned investment to maintain the desired level of income.

Further, its importance lies in the multiplier theory. The higher the MPC,

the higher the multiplier and vice versa. The MPC is low in the case of the

rich people and high in the case of the poor. This accounts for high MPC in

underdevel-oped countries and low in advanced countries.

3. Keynes’s Psychological Law of Consumption:

Keynes propounded the fundamental Psychological Law of Consumption

which forms the basis of the consumption function. He wrote, “The

fundamental psychological law upon which we are enti-tled to depend with

great confidence both a prior from our knowledge of human nature and

from the detailed facts of experience, is that men are disposed as a rule and

on the average to increase their consumption as their income increases but

not by as much as the increase in their income.” The law implies that there

is a tendency on the part of the people to spend on consumption less than

the full increment of income.

58

Propositions of the Law:

This law has three related propositions:

(1) When income increases, consumption expenditure also increases but by a smaller amount. The reason is that as income increases, our

wants are satisfied side by side, so that the need to spend more on

consumer goods diminishes. It does not mean that the consumption

expenditure falls with the in-crease in income. In fact, the

consumption expenditure increases with increase in income but less

than proportionately.

(2) The increased income will be divided in some proportion between

consumption expenditure and saving. This follows from the above

proposition because when the whole of increased income is not spent

on consumption, the remaining is saved. In this way, consumption

and saving move together.

(3) Increase in income always leads to an increase in both consumption

and saving. This means that increased income is unlikely to lead

either to fall in consumption or saving than before. This is based on

the above propositions because as income increases consumption

also increases but by a smaller amount than before which leads to an

increase in saving. Thus with increased income both consumption

and saving increase.

The three propositions of the law can be explained with the help of the

following Table 3.

59

Three propositions of the Keynes’s Psychological Law of Consumption

Proposition (1):

Income increases by Rs 60 crores and the increase in consumption is by Rs

50 crores. The consumption expenditure is, however, increas-ing with

increase in income, i.e., Rs 170, 220, 270 and 320 crores against Rs 180,

240, 300 and 360 crores respectively.

Proposition (2):

The increased income of Rs 60 crores in each case is divided in some

proportion between consump-tion and saving (i.e., Rs 50 crores and Rs 10

crores).

Proposition (3):

As income increases from Rs 120 to 180, 240, 300 and 360 crores,

consumption also increases from Rs 120 to 170, 220, 270, 320 crores, along

with in- crease in saving from Rs 0 to 10, 20, 30 and 40 crores

re-spectively. With increase in income neither consumption nor saving has

fallen.

Diagrammatically, the three propositions are explained in Figure 3. Here,

income is measured horizontally and consumption and saving are

measured on the vertical axis. С is the consumption function curve and 45°

line represents income.

Three propositions of the Keynes’s Psychological Law of

Consumption

60

Proposition (1):

When income increases from OY0 to OY1 consumption also increases from ВY0 to С1 Y1 but the increase in consumption is less than the increase in

income, i.e., C1K2 < A1Y1 (=OY1) by A1 C1

Proposition (2):

When income increases to ОY1 and OY2, it is divided in some proportion between consumption C1T1 and C2Y2 and saving A1C1 and A2C2

respectively.

Proposition (3):

Increases in income to OY1 and OY2 lead to increased consumption C2Y2> C1Y1 and increased saving А2С2>А1С1 than before. It is clear from the

widening area below the С curve and the saving gap between 45° line and С

curve.

It’s Assumptions:

Keynes’s Law is based on the following assumptions:

1. It assumes a Constant Psychological and Institutional

Complex:

This law is based on the assumption that the psychological and institutional

complexes influencing consumption expenditure remain constant. Such

complexes are income distribution, tastes, habits, social customs, price

move-ments, population growth, etc. In the short run, they do not change

and consumption depends on income alone. The constancy of these

complexes is the fundamental cause of the stable consumption function.

2. It assumes the Existence of Normal Conditions:

The law holds good under normal condi-tions. If, however, the economy is

faced with abnormal and extraordinary circumstances like war, revolution

or hyperinflation, the law will not operate. People may spend the whole of

increased income on consumption.

61

3. It assumes the Existence of a Laissez-faire Capitalist Economy:

The law operates in a rich capitalist economy where there is no government intervention. People should be free to spend increased income. In the case

of regulation of private enterprise and consumption expenditures by the

state, the law breaks down. Thus the law is inoperative in socialist or state

controlled and regulated economies.

Professor Kurihara opines that “Keynes’s law based on these assumptions

may be regarded as a rough approximation to the actual macro-behaviour

of free consumers in the normal short period”.

4. Implications of Keynes’s Law (Or Importance of the Con-

sumption Function):

Keynes’s psychological law has important implications which in fact point

towards the impor-tance of the consumption function because the latter is

based on the former.

The following are its implications:

1. Invalidates Say’s Law:

Say’s Law states that supply creates its own demand. Therefore, there

cannot be general overproduction or general unemployment. Keynes’s

psychological law invalidates Say’s Law because as income increases,

consumption also increases but by a smaller amount.

In other words, all that is produced (income) is not taken off the market

(spent), as income increases. Thus supply fails to create its own demand.

Rather it exceeds demand and leads to general overproduction and glut of

commodities in the market. As a result, producers stop production and

there is mass unemployment.

2. Need for State Intervention:

As a corollary to the above, the psychological law highlights the need for

state intervention. Say’s Law is based on the existence of laissez-faire policy

and its refutation implies that the economic system is not self-adjusting. So

when consumption does not increase by the full increment of income and

62

consequently there is general overproduction and mass unemployment, the

necessity of state intervention arises in the economy to avert general

overproduction and unemployment through public policy.

3. Crucial Importance of Investment:

Keynes’s psychological law stresses the vital point that people fail to spend on consumption the full increment of income. This tendency creates a gap

between income and consumption which can only be filled by either

increased investment or consumption. If either of them fails to rise, output

and employment will inevitably fall.

Since the consumption function is stable in the short-run, the gap between

income and consumption can only be filled by an increase in investment.

Thus the psychological law emphasises the crucial role of investment in

Keynes’s theory. It is the inadequacy of investment which results in

unemployment and logically, the remedy to over-come unemployment is

increase in investment.

4. Existence of Underemployment Equilibrium:

Keynes’s notion of underemployment equilib-rium is also based on the

psychological law of consumption. The point of effective demand which

determines the equilibrium level of employment is not of full employment

but of underemployment because consumers do not spend the full

increment of their income on consumption and there remains a deficiency

in aggregate demand. The full employment equilibrium level can, however,

be reached if the state increases investment to match the gap between

income and consumption.

5. Declining Tendency of the Marginal Efficiency of Capital:

The psychological law also points towards the tendency of declining

marginal efficiency of capital in a laissez-faire economy. When income

63

increases and consumption does not increase to the same extent, there is a

fall in demand for consumer goods.

This results in glut of commodities in the market. The producers will reduce

production which will, in turn, bring a decline in the demand for capital

goods and hence in the expected rate of profit and business expectations. It

implies a decline in the marginal efficiency of capital.

It is not possible to arrest this process of declining tendency of marginal

efficiency of capital unless the propen-sity to consume rises. But such a

possibility can exist only in the long run when the psychological law of

consumption does not hold good.

6. Danger of Permanent Over-saving or Under-investment Gap:

Keynes’s psychological law points out that there is always a danger of

an over-saving or under-investment gap appearing in the capitalist

economy because as people become rich the gap between income and

consumption widens.

This long-run tendency of increase in saving and fall in investment is

characterised as secular stagna-tion. When people are rich, their propensity

to consume is low and they save more. This implies low demand which

leads to decline in investment. Thus the tendency is for secular stagnation

in the economy.

7. Unique Nature of Income Propagation:

The fact that the entire increased income is not spent on consumption

explains the multiplier theory. The multiplier theory or the process of

income propaga-tion tells that when an initial injection of investment is

made in the economy, it leads to smaller succes-sive increments of income.

This is due to the fact that people do not spend their full increment of

income on consumption. In fact, the value of multiplier is derived from the

marginal propensity to consume, i. e., Multiplier = 1—1 /МРС. The higher

the MPC, the higher the value of the multiplier, and vice versa.

64

8. Explanation of the Turning Points of the Business Cycles:

This law explains the points of a business cycle. Before the economy reaches the full employment level, the downturn starts because people fail

to spend the full increment of their income on consumption. This leads to

fall in demand, overproduction, unemployment and decline in the marginal

efficiency of capital. Figure 4 Panel (A) shows this downturn move-ment.

When income increases above the breakeven point by Y’Y”, consumption

ex-penditure increases by a smaller amount C’C”, (C’C” < Y’Y”). Before the

economy reaches the full-employment income level YF, the downturn will

start because the gap between 45° line and С curve continues to widen.

Conversely, the upturn in the economy starts before it reaches the stage of

complete depression because when income falls, consumption also falls but

by less than the fall in income. People continue to buy consumer goods even

when their income falls. So when the excess stock of commodities is

exhausted in the community during a depression, the existence of

consumer expenditure on goods leads to revival.

This is best explained with the help of Figure 4 Panel (B) where below the

breakeven point B, the С curve is above the 45° income line. The fact that

the consumption function curve С is above the income line shows that

revival will start before income falls to zero. This is because the fall in

consump-tion C’C” is less than the fall in income Y’Y.

65

5. Determinants of the Consumption Function:

Keynes mentions two principal factors which influence the consumption function and determine its slope and position. They are (1) the subjective

factors, and (2) the objective factors. The subjective factors are endogenous

or internal to the economic system. They include psychological

characteristics of human nature, social practices and institutions and social

arrangements. They “are unlikely to undergo a material change over a short

period of time except in abnormal or revolutionary circum-stances.” They,

therefore, determine the slope and position of the С curve which is fairly

stable in the short-run.

The objective factors are exogenous or external to the economic system.

They may, therefore, undergo rapid changes and may cause marked shifts

in the consumption function (i.e., the С curve).

1. Subjective Factors:

Keynes’s subjective factors basically underlie and determine the form (i.e., slope and position) of the consumption function. As already noted above,

the subjective factors are the psychological charac-teristics of human

nature, social practices and institutions, especially the behaviour patterns

of business concerns with respect to wage and dividend payments and

retained earnings, and social arrangements affecting the distribution of

income.

(1) Individual Motives:

There are eight motives “which lead individuals to refrain from spending

out of their incomes.”

They are:

(i) The desire to build reserves for unforeseen contingencies;

(ii) The desire to provide for anticipated future needs, i.e., old age,

sickness, etc.;

(iii) The desire to enjoy an enlarged future income by way of interest

and appreciation;

(iv) The desire to enjoy a gradually increasing expenditure in order to

improve the standard of living;

(v) The desire to enjoy a sense of independence and power to do

things;

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(vi) The desire to secure a “masse de Manoeuver” to carry out

speculative or business projects; (vii) The desire to bequeath a fortune; and

(viii) The desire to satisfy a pure miserly instinct.

(2) Business Motives:

The subjective factors are also influenced by the behaviour of business corporations and governments.

Keynes lists four motives for accumulation on their part:

(i) Enterprise, the desire to do big things and to expand;

(ii) Liquidity, the desire to meet emergencies and difficulties

successfully;

(iii) Income raise, the desire to secure large income and to show

successful management; and

(iv) Financial prudence, the desire to provide adequate financial

resources against depreciation and obsolescence, and to discharge

debt.

These factors remain constant during the short-run and keep the consumption function stable.

2. Objective Factors:

The objective factors which undergo rapid changes and cause marked shifts

in the consumption function are:

1. Change in the Wage Level:

If the wage rate rises, the consumption function shifts upward. The workers

having a high propensity to consume spend more out of their increased

income and this tends to shift the С curve upward. If, however, the rise in

the wage rate is accompanied by a more than proportionate rise in the price

level, the real wage rate will fall and it will tend to shift the С curve

downward. A cut in the wage rate will also reduce the consumption function

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of the community due to a fall in income, employment and output. This will

shift the curve downward.

2. Windfall Gains or Losses:

Unexpected changes in the stock market leading to gains or losses

tend to shift the consumption function upward or downward. For instance,

the phenomenal windfall gains due to the stock market boom in the

American economy after 1925 led to a rise in the consumption spending of

the stock holders by roughly in proportion to the increased income and as a

result the consumption function shifted upward. Similarly, unexpected

losses in the stock market lead to the downward shifting of the С curve.

3. Changes in the Fiscal Policy:

Changes in fiscal policy in the form of taxation and public expenditure

affect the consumption function. Heavy commodity taxation adversely

affects the con-sumption function by reducing the disposable income of the

people.

This is what actually happened during the Second World War when the

consumption function shifted downward due to heavy indirect taxation,

rationing and price controls. On the other hand, the policy of progressive

taxation along with that of public expenditure on welfare programmes

tends to shift the consumption function upward by altering the distribution

of income.

4. Changes in Expectations:

Changes in future expectations also affect the propensity to con-sume. If a

war is expected in the near future, people start hoarding durable and semi-

durable commodi-ties in anticipation of future scarcity and rising prices. As

a result, people buy much in excess of their current needs and the

consumption function shifts upward.

On the contrary, if it is expected that prices are likely to fall in the future,

people would buy only those things which are very essential. It will lead to a

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fall in consumption demand and to a downward shift of the consumption

function.

5. Changes in the Rate of Interest:

Substantial changes in the market rate of interest may influence the

consumption function indirectly. There are several ways in which the rate

of interest may affect the consumption function. A rise in rate to interest

will lead to a fall in the price of bonds, thereby discouraging the propensity

to consume to the bond holders.

It may also have the effect of substituting one type of assets for another.

People may be encouraged to save rather than invest in bonds. In case they

are buying durable consumer goods like refrigerators, scooters, etc. on hire-

purchase system they will tend to postpone their purchases when the rate of

interest rises. They will have to pay more in installments and thus their

consumption function will shift downward. Keynes wrote, “Over a long

period, substantial changes in the rate of interest probably tend to modify

social habits considerably.

Besides, these five factors, Keynes also listed changes in accounting practice

with respect to depreciation. This factor has been rejected by Hansen who

opines that “it is not a factor which can be thought to change violently in

the short-run and it was a mistake for Keynes to include it here. How-ever,

we add some of the other objective factors listed by Keynes’s followers.

6. Financial Policies of Corporations:

Financial policies of corporations with regard to income retention, dividend

payments and reinvestments tend to affect the consumption function in

several ways. If corporations keep more money in the form of reserves,

dividend payments to shareholders will be less, this will have the effect of

reducing the income of the shareholders and the consumption function will

shift downward.

Moreover “a lag between corporate profits and dividend payments tends to

slow up the ‘multiplier’ process of consumption responding and income

propagation…For excessive corporate savings, however prudent from the

standpoint of individual corporations, not only reduce consumption

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expenditures but may also make it ‘almost hopeless to find still more new

investment, as ,Keynes put it.”

7. Holding of Liquid Assets:

The amount of liquid assets in the form of cash balances, savings and

government bonds in the hands of consumers also influence the

consumption function. If people hold larger liquid assets they will have a

tendency to spend more out of their current income and the propensity to

consume will move upward, and vice versa. Pigou was of the view that with

a cut in money wage, prices fall and the real value of such assets increases.

This tends to shift the consumption function upward. This is called the

“Pigou Effect.” But it is not necessary for the Pigou effect to take place via

money wage-cut. An increase in the real value of such accumulated savings

takes place directly through a fall in prices and a decrease in their value

through price inflation. In the former case, asset holders tend to spend

more on consumption and in the latter case less on consumption. If, how-

ever, the low income groups hold such liquid assets, the tendency would be

for the consumption function to shift upward because their propensity to

consume is high.

8. The Distribution of Income:

The distribution of income in the community also determines the shape of

the consumption function. If there are large disparities in income

distribution between the rich and the poor, the consumption function is low

because the rich have a low propensity to consume and the poor with a very

low income are unable to spend more on consumption.

If through progressive taxation and other fiscal measures, the inequalities

of income and wealth are reduced, the consumption function will shift

upward because with the increase in the income of the poor their

consumption expenditure will increase more than the reduction in the

expenditure of the rich. “Moreover, if the distribution of income is

significantly altered for political or humanitarian reasons, consumer habits

themselves may undergo such changes as to cause the position or shape of

the entire consumption function to vary perceptibly.”

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9. Attitude toward Saving:

The consumption function is also influenced by people’s attitude toward saving. It they value future consumption more than present consumption,

they will tend to save more and the consumption function will shift

downward. This tendency may be reinforced by the state through

compulsory life insurance, provident fund and other social insurance

schemes to keep the consumption function low. In a high saving economy,

the consumption function is low.

10. Duesenberry Hypothesis:

James Duesenberry has propounded a relative income hypothesis affecting

the consumption function. The first part of this hypothesis relates to the

‘demonstration effect. I here is a tendency in human beings not only to keep

up with the Joneses but also to surpass the Joneses, that is, the tendency is

to strive constantly toward a higher consumption level and to emulate the

consumption patterns to one’s rich neighbours and even to surpass them.

Thus consumption pref-erences are interdependent. The second part is the

‘past peak of income’ hypothesis which explains the short-run fluctuations

in consumption. Once the community reaches a particular income level and

standard of living, it is reluctant to come down to a lower level of

consumption during a recession. Consumption is sustained by the

reduction in current saving and vice versa. So there is no shift in the

consumption function during the short-run. There is simply an upward-

downward movement on the same consumption function when income

rises or falls during the short-run.

We may conclude with Professor Hansen “that except for quite abnormal or

revolutionary changes in certain objective factors—expectations caused by

unusual events such as wars, earthquakes, strikes, revolutions, etc., major

changes in the tax structure, quite exceptional windfall losses or gains—

apart from such drastic changes, shifts in the ‘propensity to consume out of

a given income’ are not likely to be of more than secondary importance.”

6. Measures to Raise the Propensity to Consume:

The propensity to consume remains stable during the short-run due to the

existence of certain psychological and institutional factors in the society.

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But “employment can only increase pari passu with an increase in

investment; unless, indeed, there is a change in the propensity to

consume,” as pointed out by Keynes. Therefore, it is significant to study the

measures which tend to raise the propen-sity to consume.

1. Income Redistribution:

Redistribution of income in favour of the poor tends to raise the propensity

to consume because the marginal propensity to consume of the low income

groups is high in comparison to the rich. Therefore, the propensity to

consume can be raised by transferring income and wealth from the rich to

the poor.

This can be done by the state through its taxation and public spending

policies. By imposing progressive taxes on incomes, expenditures, estates,

capital gains, etc., the state is able to mobilise larger revenues for providing

more facilities to the poor. But care should be taken that such taxation

should not adversely affect investment.

Secondly, the state can increase the income of the poor through judicious

public expenditure programmes. By starting public works, it is in a position

to increase income by providing larger employment opportunities to the

unemployed. The provision for free education., free mid-day meals, free

health services, low-rent housing, etc. indirectly helps in increasing the

income of the workers and tends to raise their consumption expenditure.

Such social expenditures by the state also increase the efficiency of the

workers which, in turn, leads to a rise in their wages.

2. Increased Wages:

If wages are raised, they will have a direct effect in shifting the consump-tion function upward. But a policy of high wages adversely affects the level

of employment in the economy, for it is not possible to raise the marginal

revenue productivity of labour in the short run.

If wages are raised in such a situation, costs will rise in the absence of

increase in the marginal revenue productivity of labour and the economy is

likely to experience unemployment. Therefore, the long run wage policy

should be such that wages increase pari passu with increase in labour

productivity. This will tend to raise the level of consumption in the

economy.

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3. Social Security Measures:

Social security measures tend to raise the consumption function in the long-run. Provisions for unemployment relief, medical facilities, old age

pension, etc. remove future uncertainties and the tendency to save is

reduced on the part of the people. The state should, therefore, provide

larger social security measures to raise the propensity to consume of the

people.

Unemployment relief and old age pensions tend to maintain high

consumption expenditure even during a depression and thus help bring

revival in the economy. So social security measures tend to raise the

consumption function both in periods of prosperity and depression.

4. Credit Facilities:

Cheap and easy credit facilities help in shifting the consumption function upward. When loans are easily and cheaply available to the people, they buy

more durable consumer goods like scooters, televisions, refrigerators, etc.

This tends to raise the propensity to consume. To purchase these things on

instalment basis or on hire-purchase system produces the same effect. Thus

credit facilities in various ways help raise the propensity to consume of

durable consumer goods.

5. Advertisement:

Advertisement is one of the most significant ways to raise the propensity to

consume in modern times. Advertisement and propaganda through the

various media of radio, televi-sion, cinema, newspaper, etc. make the

consumers familiar with the uses of products. The consumers are attracted

toward them and they tend to buy them. This raises their propensity to

consume.

6. Development of the Means to Transport:

Well developed means of transport also tend to shift the consumption function upward. The movement of goods from the manufacturing centres

to the different parts of the country becomes easy. The size of the market

expands. The prices may also fall due to the reduction of transport costs.

Things are available to the people in their respective towns. All this has the

tendency to raise the consumption function.

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7. Urbanisation:

As a corollary to the above, urbanisation helps raise the propensity to consume. When urbanisation takes place, people move from the rural to the

urban areas. They are enamoured by new articles and influenced by the

demonstration effect. This tends to shift the consumption function upward.

Thus the state should follow the policy of deliberate urbanisation for the

purpose of raising the consumption function.

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INVESTMENT FUNCTION IN AN ECONOMY:

The level of income, output and employment in an economy depends upon

effective demand, which in turn, depends upon expenditures on

consumption goods and investment goods (Y = C + I).

Consumption depends upon the propensity to consume, which, we have

learnt, in more or less stable in the short period and is less than unity.

Greater reliance, therefore, has to be placed on the other constituent

(investment) of income.

Out of the two components (consumption and investment) of income,

consumption being stable, fluctuations in effective demand (income) are to

be traced through fluctuations in investment. Investment, thus, comes to

play a strategic role in determining the level of income, output and

employment at a time.

We can establish the importance of investment in another way also. In

order to maintain an equilibrium level of income (Y = C + I), consumption

expenditures plus investment expenditures must equal the total income

(Y); but according to Psychological Law of Consumption given by Keynes,

as income increases consumption also increases but by less than the

increment in income. This means that a part of the increment in income is

not spent but saved.

The savings must be invested to bridge the gap between an increase in

income and consumption. If this gap is not plugged by an increase in

investment expenditures, the result would be an unintended increase in the

stocks of goods (inventories), which in turn, would lead to depression and

mass unemployment. Hence, investment rules the roost. In Keynesian

economics investment means real investment i.e., investment in the

building of new machines, new factory buildings, roads, bridges and other

forms of productive capital stock of the community, including increase in

inventories.

It does not include the purchase of existing stocks, shares and securities,

which constitute merely an exchange of money from one person to another.

Such an investment is merely financial investment and does not affect the

level of employment in an economy. An investment is termed real

investment only when it leads to a increase in the demand for human and

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physical resources, resulting in an increase in their employment.

Investment is a flow variable and its counterpart is stock variable called

capital.

Types of Investment:

Investment may be private investment or public investment, it may be induced or autonomous. Induced investment is that investment which

changes with a change in income, that is why it is called income, elastic. In

a free enterprise capitalist economy, investments are induced by profit

motive. Such investment is very responsive to changes in income, i.e.,

induced investment increases as income increases. The shape of the

induced investment curve, therefore, is upward sloping, indicating a rise in

investment as a result of rise in income.

According to Hicks, investment is of two types, induced as described above

and autonomous— it is independent of variations in output. Explaining

autonomous investment, Hicks remarks: “Public investment, investment

which occurs in direct response to inventions and much of the long range

investment (as Mr. Harrod calls it) which is only expected to pay for itself

over a long period, all of these can be regarded as autonomous

investments.”

Autonomous investment is not sensitive to changes in income. In other

words, it is independent of income changes and is not guided or induced by

profit motive only. Autonomous investments are made primarily by the

Government and are not based on considerations of profit.

Autonomous investments are a peculiar feature of a war or a planned

economy, for example, expenditures on arms and equipment to strengthen

the defence of India may be called autonomous investment as it is incurred

irrespective of the level of income or profits. Prof. Hansen maintained that

autonomous investment is generally associated with such factors as

introduction of new production techniques, products, development of new

resources or growth of population.

Induced investment is undertaken specially to produce large output. The

curve of autonomous investment is represented by a straight line running

from left to right and parallel to the horizontal income axis.

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Gross Investment and Net Investment:

Investment, as we have seen which is in the nature of How of expenditures, during a given time period, on view fixed capital goods or is

in the nature of an addition to the stock of raw materials and unsold

consumer goods is called gross investment. However, replacement of

investment denotes to the expenditures incurred to maintain the stock of

capital, in an economy, intact. This type of expenditure is undertaken to

offset the depreciation, wear and tear and obsolescence in the existing

productive capacity. Net investment is, thus, the excess of gross investment

over the replacement investment. The term net investment is, therefore,

sometimes used for capital formation also.

Symbolically:

Ig = In + Ir

where Ig is the gross investment, In the net investment and Ir the

replacement investment also called capital consumption. It is the variations

in the In which causes fluctuations in Y, O and E both in the short-run and

in the long-run. If during a period Ig> Ir, it means that In is positive and

the stock of capital is increasing equal to In thereby leading to an increase

in the capacity to produce. If Ir > Ig, then In is negative and the stock of

capital may decrease having unfavourable effects on the productive

capacity. If, however, Ig = Ir, then In = O and it means that the economy is

just making good the loss in capacity to produce on account of obsolescence

and depreciation.

It may not be out of place to mention that net investment may also include expenditures on new durable consumer goods besides the expenditure on

new capital goods. Therefore, in a sense, it would be more appropriate to

define net investment as the net addition to the stock of capital including

the producer and durable consumer goods. Capital here means

accumulation in the stock of plant and equipment held by business units. It

is therefore, clear that for economic growth, that is, if the economy is to

grow over time its capital stock must also grow.

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Determinants of Investment:

Private investment (induced investment) depends upon the marginal efficiency of capital and the rate of interest. The marginal efficiency of

capital, in turn, depends upon future expectations which fluctuate violently.

Hence, private investment becomes highly capricious and is very low, when

in fact, it should be very high.

Prospective entrepreneurs keep on comparing the marginal efficiency of

capital with the rate of interest and decide to invest only when the former is

higher than the later. There will be no investment if the rate of interest is

higher than the MEC. (In other words, if profit expectations are not very

bright); that is the reason why investments fall to low levels during

depression period, despite the fact that all types of encouragements are

given to private investors to invest more.

Classical economists regarded investment as dependent on the rate of

interest; this to them was an important lever by which investment in the

system was regulated. This is why they relied too heavily on the rate of

interest to control fluctuations. They always held that by manipulating the

rate of interest, stability in the economic system could be restored. Until the

Great Depression of the 1930s.

Keynes also adhered to this view and believed in the efficacy of the rate of

interest in solving the problem of cyclical fluctuations. But later on, he

realized its weaknesses and stopped giving it undue importance as cyclical

stabilizer. Keynes realized that investment depended more on the

psychological factors like the marginal efficiency of capital and not on the

rate of interest; as such, it was relegated to the background. It is, no doubt,

true that the marginal efficiency of capital has become the chief

determinant of investment yet the influence of interest cannot be ignored as

both go to determine it.

The significant role of public investment, also called the autonomous

investment, which the Government may incur to save the economy from

falling further to lower income levels, comes to the forefront. In the nature

of the case, public investment is independent of the profit motive. Since a

steady investment is essential for the investment multiplier to have positive

effect on income, output and employment, during depression, motives

other than profit are necessary to guide more investment— a function

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which is fulfilled only by public investment. Further, the amount of public

investment cannot only be controlled but is capable of expansion to such an

extent to make the investment multiplier work with greater force than

would otherwise be possible.

Moreover, the government can prevent it from leaking out of the spending

stream, as well as is capable of timing it, so as to let the multiplier have its

full and free play. There is no reason why public investment should not be

wealth- creating as well as employment-generating and why its adverse

tertiary effects (if any) cannot be offset as a result of the beneficial effects of

multiplier on private consumption. Hence, the importance of public

investment. It, therefore, becomes necessary to analyze the various

measures which stimulate investment.

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MULTIPLIER EFFECT

The multiplier effect refers to the proportional amount of increase in final income that results from an injection of spending. Alternatively, a multiplier effect can also work in reverse, showing a proportional decrease in income when spending falls. Generally, economists are usually the most interested in how capital infusions positively affect income. Most economists believe that capital infusions of any kind, whether it be at the governmental or corporate level, will have a broad snowball effect on various aspects of economic activity.

Multiplier Effect Explained Like its name, the multiplier effect involves a multiplier that provides

a numerical value or estimate of an expected increase in income per dollar of investment. In general, the multiplier used in gauging the multiplier effect is calculated as follows:

Change in Income / Change in Spending

The multiplier effect can be seen in several different types of scenarios and used by a variety of different analysts when analyzing and estimating expectations for new capital investments.

For a basic example, assume a company makes a $100,000 investment of capital to expand its manufacturing facilities in order to produce more and sell more. After a year of full production with the new facilities, the company’s income increases by $200,000. When isolating the $200,000 and $100,000 for use in the multiplier effect the company’s multiplier would be 2 ($200,000/$100,000). This shows that for every $1 they invested, they earned an extra $2.

IMPORTANT POINTS

• In general, the most basic multiplier used in gauging the multiplier effect is calculated as change in income / change in spending.

• The multiplier effect can be used by companies or calculated on a larger scale with the use of GDP.

• Economists may view the multiplier effect from several angles including usage of a calculation involving marginal propensity to consume.

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• The money supply multiplier is also another variation of a standard multiplier, using a money multiplier equation to analyze multiplier effects on the money supply.

Broader Economic Views Many economists believe that new investments can go far beyond just

the effects of a company’s income. Thus, depending on the type of investment, it may have widespread effects on the economy at large. A key tenet of Keynesian economic theory is the notion that economic activity can be easily influenced by investments causing more income for companies, more income for workers, more supply, and ultimately greater aggregate demand. Therefore, on a macro level, different types of economic multipliers can be used to help measure the impact that changes in investment have on the economy.

When looking at the economy at large, the multiplier would be the change in real GDP divided by the change in investments. Investments can include government spending, private investments, taxes, interest rates, and more.

When estimating the effects of $100,000 by the manufacturing company on the economy overall, the multiplier would be much smaller. For example, if GDP grew by $1 million, the multiplier effect of this investment would be 10 cents per dollar.

Some economists also like to factor in estimates for savings and consumption. This involves a slightly different type of multiplier. When looking at savings and consumption, economists might measure how much of the added economic income consumers are saving versus spending. If consumers save 20% of new income and spend 80% of new income then there marginal propensity to consume (MPC) is 0.8. Using an MPC multiplier, the equation is 1/(1-MPC). Therefore in this example, every new production dollar creates extra spending of $5 (1/(1-.8).

Money Supply Multiplier Effects Economists and bankers often look at a multiplier effect from the

perspective of banking and money supply. This multiplier is called the money supply multiplier or just the money multiplier. The money multiplier involves the reserve requirement set by the board of governors of the Federal Reserve System and it varies based on the total amount of liabilities held by a particular depository institution. The most recent

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Federal Reserve, reserve requirements require institutions with more than $124.2 million to have reserves of 10%.

In general, the money supply across the entire U.S. economy consists of multiple levels. The first level refers to all of the physical currency in circulation within an economy (usually M1). The next level adds the balances of short-term deposit accounts for a summation called M2.

When a customer makes a deposit into a short-term deposit account, the banking institution can lend one minus the reserve requirement to someone else. While the original depositor maintains ownership of the initial deposit, the funds created through lending are generated based on those funds. If a second borrower subsequently deposits funds received from the lending institution, this raises the value of money supply even though no additional physical currency actually exists to support the new amount.

Most economists view the money multiplier in terms of reserve dollars and that is what the money multiplier formula is based on. Theoretically, this leads to a money (supply) reserve multiplier formula of: 1/Reserve Requirement Ratio

When looking at banks with the highest required reserve requirement of 10%, their money supply reserve multiplier would be 10 (1/.10). This means every one dollar of reserves should have $10 in money supply deposits.

The money supply multiplier effect can be seen in a country's banking system. An increase in bank lending should translate to an expansion of a country's money supply. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. When the reserve requirement decreases the money supply reserve multiplier increases and vice versa.

If the reserve requirement is 10%, then the money supply reserve multiplier is 10 and the money supply should be 10 times reserves. When a reserve requirement is 10%, this also means that a bank can lend 90% of its deposits.

Looking at the example below provides some additional insight.

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Money Supply Multiplier Example. Looking at the money multiplier in terms of reserves helps best to

understand the amount of expected money supply. When banks have a reserve requirement of 10%, there should be 10 times the total reserves in money supply. In this example, $651 equates to reserves of $65.13. If banks are efficiently using all of their deposits, lending out 90%, then reserves of $65 should result in money supply of $651. If banks are lending more than their reserve requirement allows their multiplier will be higher creating more money supply. If banks are lending less their multiplier will be lower and the money supply will also be lower. Moreover, when 10 banks were involved in creating total deposits of $651.32, these banks generated new money supply of $586.19 for a money supply increase of 90% of the deposits.

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ACCELERATOR

Meaning of Accelerator:

The multiplier and the accelerator are not rivals: they are parallel concepts.

While multiplier shows the effect of changes in investment on changes in

income (and employment), the accelerator shows the effect of a change in

consumption on private investment.

“Since the production of any given amount of final output usually requires

an amount of capital several times larger than the output produced with it

during any short period (say a year) any increase in final demand will give

rise to an additional demand for capital goods several times larger than the

new final demand.”

The Principle of Acceleration states that if the demand for consumption

goods rises, there will be an increase in the demand for the equipment, say

machines, which produce these goods. But the demand for the machines

will increase at a faster rate than the increase in demand for the product.

The accelerator, therefore, makes the level of investment a function of the

rate of change in consumption and not of the level of consumption. In other

words, the accelerator measures the changes in investment goods

industries as a result of long-term changes in demand in consumption

goods industries.

The idea underlying the accelerator is of a functional relationship between

the demand for consumption goods and the demand for machines which

make them. The acceleration coefficient is the ratio between induced

investments to a given net change in consumption expenditures.

v =∆//∆C

Symbolically where v stands for acceleration coefficient; ∆I denotes the net

changes in investment outlays; and ∆C denotes the net change in

consumption outlays. Suppose an additional expenditure of Rs. 10 crores

on consumption goods leads to an added investment of Rs. 20 crores in

investment goods industries, then the accelerator is 2. The actual value of

the accelerator can be one or even less than that.

In actual world, however, increased expenditures on consumption goods

always lead to increased expenditures on capital goods. Hence acceleration

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coefficient is usually greater than zero. Where a good deal of capital

equipment is needed per unit of output, the acceleration coefficient is very

much more than unity.

In exceptional cases, the accelerator can be zero also. Sometimes it so

happens that production of increased consumer goods (as a result of a rise

in their demand) does not lead to an increase in the demand for capital

equipment producing these goods.

The existing machinery also wears out on account of over use, with the

result that the increased demand for consumer goods cannot be met. It

actually happened in India and Turkey during the Second World War.

Additional investment funds were not available. In the absence of induced investment and acceleration effects, the increased demand for consumption

levelled off and the accelerator, which measures the effects of induced

investment (in investment goods industries) as a result of changes in

consumption did not seem to work during all-these years.

The factual basis of the acceleration principle is the knowledge that

fluctuations in output and employment in investment goods industries are

greater than those in consumption goods industries. Accelerator has greater

applicability to the industrial sector of the economy; and as such it seeks to

analyse the problem as to why fluctuations in employment in the capital

goods industries are more pronounced than those in the consumption

goods industries.

There would be no acceleration effects in an economy which used no capital

goods. But that situation is very rare. The more capitalized the methods of

production are, the greater must be the value of accelerator.

The principle of acceleration is basically a concept related to net

investment. Therefore, we must derive an expression linking the accelerator

with net investment. We know that gross investment has two components:

net investment plus replacement of capital wearing out due to depreciation.

We can write

Gross Investment = Igt= V(Yt-Yt-1) +R

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which means that the quantum of gross investment in period t depends

upon the value of acceleration effects of the change in income in the

previous period and the need for replacement of capital.

Inet =V(Yt-Yt–1)

Thus, net investment in period t is which means that net investment

depends only on the rate of change of income and the accelerator (V).

Multiplier and Accelerator Distinguished

For a clear grasp of the concept of accelerator, it is useful to distinguish

between multiplier and accelerator. Multiplier shows the effect of a change

in investment on income and employment whereas accelerator shows the

effects of a change in consumption on investment. In other words, in the

case of multiplier, consumption is dependent upon investment, whereas in

the case of accelerator investment is dependent upon consumption.

Further, multiplier depends upon the propensity to consume and

accelerator depends upon durability of the machines. In other words, the

former is dependent upon psychological factors, while the latter is

dependent upon technological factors. However, even accelerator is

psychological in its origin because it is linked to induced investment but it

becomes highly technical on the operational plane. The accelerator shows

the reaction (effect) of changes in consumption on investment and the

multiplier shows the reaction of consumption to increased investment.

Further, another very important point of difference between the multiplier

and accelerator is in their working backwards. Multiplier works as

rigorously in the reduction of income as it does in its increase. But the

working of the accelerator is restricted in the downward direction to the

rate of replacement of capital because businessmen can at the most

disinvest to the extent of not replacing the wearing-out capital.

Working of the Accelerator:

It is interesting to analyse the working of the Principle of Acceleration.

Accelerator depends primarily upon two factors:

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(i) The capital-output ratio, and

(ii) The durability of the capital equipment.

A numerical example will clarify the dependence of acceleration value on the durability of the machine, capital-output ratio being given.

The following table 11.1 is meant to make two things clear about the

accelerator:

(i) Given the same percentage change in consumption, the percentage

change in induced investment depends directly on the durability of

the machine. Greater is the life (durability) of the machine, greater

the value of the accelerator;

(ii) Accelerator does not depend upon the change in the absolute level

of consumption; it depends upon the rate of change of

consumption.

In Case I in the Table, we assume that we need 100 machines to produce

1000 consumer goods (capital-output ratio being 1:10). Further we

presume that the life of the machine (durability) is 10 years. Thus, after 10

years, the machine has to be replaced and 10 machines have to be replaced

in each period in order to maintain the flow of 1000 consumer goods. This

is called ‘Replacement Demand.’

Now suppose there are 10% rise in the demand for consumer goods in

period I (as shown in case I); the change in consumption will be of 100 such

goods and we will need 110 machines to produce these goods (at the

constant capital- output ratio of 1: 10). Thus, we need 20 machines in all, 10

machines being the addition to the stock of capital and 10 machines for

replacement.

Thus, a 10% rise in the demand for consumer goods leads to a 100% rise in

the demand for investment goods (machines). This is what the principle of

acceleration is intended to show. Accelerator shows that a small increase in

consumption is likely to result in manifold increase in investment (called

induced investment).

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Table 11.1

Value of the Accelerator Depends on the Durability of the Investment

Goods and the Rate of Change of Consumption Expenditure

Assumptions: (i) Capital-output ratio 1: 10 for all the Cases.

Now in case II, where the life of the machine is 20 years, other things being

the same, a rise in the demand for consumer goods in the first period leads

to 200% increase in gross investment.

Further, in case III, when the life of machine is 5 years, a 10% rise in the

demand for consumer goods results merely in an increase of 50% in gross

investment. It is, therefore, clear that:

Greater the durability (life) of the machine, the greater the value of the accelerator and higher the acceleration effect; smaller the durability, lower

the value of the accelerator and lower are the acceleration effects.

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In case IV, where we presume the life of the machines to be 10 years and

capital-output ratio constant at 1: 10 (i.e., we need 100 machines to produce

1000 goods), we find that a 10% rise in demand in period I in consumption

goods sector leads to 100% increase in gross investment, whereas in period

V, when the demand for consumer goods does not rise and remains

constant at 1000, there is a decline of 50% in gross investment.

Thus, we find that, even when there is no decrease in the demand for

consumer goods, there is likely to be a decline in gross investment. The case

demonstrates the sensitivity of investment to a cessation of economic

activity. It is to be noted that it is the falling off in the rate of increase in

consumption and not a decline in the absolute level of consumption which

causes the contraction in the demand for machines.

Further, in case V, presuming the life of the machine to be 10 years, we find

that we need machines to produce 1000 consumer goods. But when there is

a fall in the demand for consumer goods to the extent of 10% in period I, we

need 90 machines to produce 900 consumer goods.

There is 100% fall in the net investment caused by 10% fall in consumption.

If, however, the demand for consumer goods falls by 20%, we would need

20% less machines and correspondingly we can expect the rate of

investment to fall by 200%. But there is a saving grace.

At the most what the producers can do is to produce no new machines at

all, i.e., not to replace existing machines. They may allow some of the

existing plants and equipment to wear out. Thus, when the economy is

moving downwards, the fall in investment becomes confined to the demand

for replacement and that can at the most fall to zero.

In other words, value of the accelerator during downward swing is limited

by the inability of the demand for investment goods to fall below the value

of replacement (depreciation) demand.

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We can state this proposition as follows:

A decline in investment resulting from a decline in the demand for consumption goods cannot exceed the rate of depreciation. A decline in

consumption which induces a decline in investment in excess of the

depreciation figure simply gives rise to excess idle capacity.

Thus, the so-called ‘accelerator’ is a more complicated tool than the

multiplier, for it depends upon the change in the rate of consumption,

which, in turn, depends upon highly capricious investment in the short

period at any rate. Therefore, as long as the basic conditions (technological

and structural) favouring investment prevail, the acceleration principle

serves as an indicator of the consumption-based inducement to invest.

Importance and Limitations of the Accelerator:

The introduction of the Principle of Acceleration enables us to understand

the process of income generation more clearly. No doubt, a certain level of

income (or employment) could be attained by multiplier action alone. But

along with accelerator the process of income propagation is speeded up.

When accelerator and multiplier join hands, more violent fluctuations in

income occur in upward and downward directions.

Firstly, this multiplier-accelerator interaction enables us to throw light on

one of the most important features of business cycle. This feature is that the

investment goods industries fluctuate more violently than the

consumption-goods industries. It has helped us to show that small demand

changes in consumption-goods industries lead to considerably enlarged

changes in investment-goods industries.

Secondly, the multiplier-accelerator interaction has profoundly increased

our understanding of business cycles. Prof. Hicks’ theory of the business

cycle is based primarily on the principle of acceleration.

Further, Prof. R.F. Harrod has based his theory of Steady Growth on the

acceleration principle. Harrod’s analysis of economic growth grew out of his

analysis of business cycle as a dynamic economic phenomenon.

Despite its great theoretical importance, its qualifications indicate that

attempts to apply very simplified models using the acceleration principle

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are likely to give misleading results. The presumptions of a fixed ratio of

consumer to capital goods, of constant replacement demand, of no excess

capacity, of permanent demand are lacking in realism. In other words,

acceleration theory is valid only so long as all machines are in use (no

excess capacity), overtime is excluded, the relation between production

factors is not altered (unchanged technology), sufficient raw materials and

labour are present and the entrepreneurs command the necessary financial

means.

Since this is not the case generally, the simple concept of accelerator as we

have studied it is of little significance. Many attempts to measure the

accelerator have yielded little result. Entrepreneurs’ behaviour is to be

explained through numerous other factors, especially future expectations

play a particularly important part. More realistic assumptions would

virtually lead to results significantly different from those obtained under

simplifying assumptions.

Conclusion:

The theory of accelerator is based upon the idea that income and the stock

of capital goods increase in flexible proportion. This is not the case where

fundamental changes in technology are changing both the capital-output

ratio and durability of the machines. Economic growth, furthermore, is not

only dependent on capital. The accelerator is not adequate to explain

changes in aggregate investment.

Only under special circumstances and in the short run there is a

proportional relationship between output and the stock of capital goods.

The acceleration principle is less general in application than the multiplier;

whereas the latter operates in both the forward and backward directions,

the accelerator is effective only in the upward direction (in the downward

direction it works only to the extent that replacement investment is not

provided for).

Thus, it is clear that at least three basic conditions must operate for a ‘pure’

accelerator model:

(i) Existing capacity is fully utilised,

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(ii) Finances are adequate to permit satisfaction of accelerator-

generated demand, (iii) The change in output is thought to be non-temporary.

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INTERACTION BETWEEN MULTIPLIER AND

ACCELERATOR

The principle of acceleration has attained more importance in cyclical theory by its alliance with the multiplier principle.

The interaction of the accelerator with the multiplier is capable, under

certain circumstances, of generating continuous cyclical fluctuations.

Economists like P.A. Samuelson, J.R. Hicks, R.F. Harrod and A. Hansen have made fairly successful attempts to integrate the two parallel concepts

and have introduced certain remarkable improvements. Neither the

multiplier nor the accelerator taken alone can act. In fact, the two tools

combine in a series of endless possibilities, depending on the values of the

accelerator and the magnitude of the multiplier. In other words, the

relationship can be expressed as follows:

∆Ia → (multiplier) → ∆Y → (accelerator) → ∆Ib → (K) → ∆Y → …

where an initial increase in autonomous investment (Ia) works through the

multiplier to cause an increase in income (∆Y), and this works through the

accelerator to cause a greater change in induced investment (lb), which, in

turn, increases income still more and so the action and the interaction

continue. The process is super-cumulative because one initial increase (or

decrease) will set off a snowball effect where income and investment

interact to magnify the impact at each successive level.

It is, therefore, quite interesting and useful to analyze the combined effects

of multiplier and accelerator on national income propagation. In order to

measure the total effects of initial expenditure on national income, we must

combine the acceleration and multiplier principles, popularly called the

‘leverage effects’. The combined effects of autonomous and induced

investment are expressed in what Hansen calls the ‘Super-Multiplier’.

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Multiplier an Acceleration Effects of Income:

Assumptions:

(i) Marginal Propensity to consume = ½=0.5

(ii) Acceleration coefficient= 2

In the table given above, we can easily see the process of income

propagation via the multiplier and acceleration principles, we assume (i)

MPC = ½ (ii) Acceleration coefficient = 2. In the first period there is an

initial outlay of Rs. 10 crore, which does not lead to any induced

investment. Hence, the total rise in national income in the first period is Rs.

10 crore (being qual to initial outlay of Rs. 10 crore).

Since the MPC = ½, therefore, the induced consumption in the second

period is Rs. 5 crore (shown in the column 3) and acceleration coefficient

being 2, the induced investment in the second period is Rs. 10 crore,

(shown in column 4) and the total leverage effects (total increase in

national income) is Rs. 25 crore (shown in column 5). Similarly, in the third

period, we get induced consumption of Rs. 12.50 crore and induced net

investment of Rs. 15 crore being twice the

and 5 crore (shown in column 3).

difference between 12.50 crore

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Thus, total income in the fourth period has reached the peak level of Rs.

41.25 crore, as a result of the combined multiplier and acceleration

interaction (called Super-Multiplier). Then, in the fifth period, the total

income starts falling and falls to rock bottom level of – 1.15 crore in 8th

period and then again starts rising from 15.52 crore to 32.12 crore and goes

upto 42.66 crore in the 11Th period, thereby completing a cycle. The result is

quite a moderate type recurring cycle which repeats itself indefinitely.

This shows that mpc of less than unity gives an answer to the question:

Why does the cumulative process come to an end before a complete

collapse or before full employment? Hansen says that the rise in income

progressively slowed down on account of a large part if the increase in

income in each successive period is not spent on consumption. This results

in a decline in the volume of induced investment and when such a decline

exceeds the increase in induced consumption, a decline in income sets in.

“Thus, it is the marginal propensity to save which calls a halt to the

expansion process even when the expansion is intensified by the process of

acceleration on top of the multiplier process.” However, we have assumed

constant values of multiplier and acceleration coefficients but in a dynamic

economy they vary cyclically. Thus, when we study the results of leverage

effects or the interaction of multiplier and acceleration coefficients, we find

that the level of income will be subject to various types of fluctuations

depending on the values of acceleration and the multiplier.

In the BELOW we measure time periods on the horizontal axis and the

increase in income on the vertical axis. The curve a to b and b to c shows

the ordinary process of income propagation (total leverage effects) as a

result of multiplier and accelerator interaction during 5 periods.

The income rises to its peak up to Rs. 41.25 crore (from a to b). This is

because the rate of increase of induced consumption goes on g 40 –

increasing from period 1 to 4, acceleration effects work g in conjunction

with the multiplier to push up the level of income. However, income falls in

the period 5 from b to c since the rate of increase in induced consumption 2

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falls. But income and investment will not keep on going higher and higher indefinitely because two forces work to cause an eventual leveling off.

Firstly, the mps and other leakages like taxes reduce the rate of

growth of consumption at each stage until the consumption finally ceases to

increase at all. Secondly, the initial increase in an autonomous investment

soon exhausts itself, because as the capital stock grows during expansion,

the MEC is likely to fall till investment is no longer profitable. Thus, while the interaction of the multiplier and accelerators magnifies economic

expansion, it also acts to set its own limits through the eventual reduction

of consumption and autonomous investment.

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FUNCTIONS OF MONEY

Economists define money via four of its basic functions. These functions will help us understand the importance and need of money as far as the economy is concerned.

Unit of Account

Say you went to a shop and started browsing around. You see the price of the products on display. They are all expressed in terms of money (rupees in this case). The cake is a hundred rupee, the pencil is ten rupees, the sneakers are a thousand rupees and so on. So as you can see, money is the basic unit of account or measurement of everything in an economy.

It is very important to have a uniform unit of account in an economy. The barter system does not work in all cases. So it is highly efficient and convenient to have a uniform base for all transactions, i.e. money. It is the foundation of every economic transaction happening anywhere around the world.

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• Supply of Money

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Medium of Exchange

This is what most economists consider the most important function of money. Money has the ability to satisfy all your unlimited needs and wants. You want the cake, or the pencil, or the sneakers, or all of them. The money will give you the ability to buy it all.

One can argue you can also barter for the goods. But then you would have to have some service or product that the shop owner wants. And it also has to be of equal value. Say the shop owner wants 5 pairs of socks in exchange for the sneakers but you do not possess them. Then you cannot buy the sneakers. The exchange can only take place if there is a double coincidence of wants. This is why money is of such essence, it makes these transactions possible with minimum effort and maximum ease.

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Store Value

Money means liquidity, i.e. it is the most liquid asset. It is the most convenient way to store wealth since you can use to buy any goods or products directly. It requires no conversion. This is what we call the store value of money.

If one was to store their wealth in other commodities, like gold or shares, there is a risk. These commodities do not have a stable value. However, money does not fluctuate in value, it’s value/worth remains stable. This is one of the biggest advantages of storing the value in money or currency.

Standard for Deferred Payment

Deferred payment is any payment that is to be made in the future. Like if you have taken a loan or buy goods on credit. The payment of these transactions has to be made on some date in the future. So these amounts are measured in terms of money. And they are ultimately paid in money as well. This is because the value of money remains stable in any economy. And so one of the most important functions of money.

DEMAND FOR MONEY

We will be seeing here the Keynesian approach for calculating the demand for money. Money is the most liquid asset in the world. We can exchange it for any commodity or service and so people prefer to hold on to their cash. But then there is also the opportunity cost of money. Instead of preferring liquidity if the money was invested it would earn interest. And so the demand for money is the balance between these two motives.

Transaction Motive

Money is a medium of exchange and this function of it’s gives rise to the transactional motive for demand for money. We regularly need money to pay for goods and services. And such financial transactions can be of two types – income motive and business motive.

The income motive is to bridge the gap between the receipt of the income and its eventual disbursement. And the business motive is to bridge the gap

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m

between the time when costs are incurred and the time when you receive the sale proceeds. If these time gaps are smaller, the person will hold less cash for his transactions and vice versa.

There may be other factors involved for the changes in transactional demand for money like the expectation of income, interest rate, business turnover etc. And from the above factors, we conclude that transactional demand for money is a directly proportional function to the level of income. We express this as

L1 = kY

Where L1 is transactional demand for money, k is the proportion of income kept for transactions and Y is income.

Speculative Motive

The other important function of money is that it is a store value of wealth, i.e. it is an asset. And the demand for any given asset depends on its opportunity cost and its rate of return. Now money does not have a rate of return but it has an opportunity cost. The opportunity cost of holding money is the interest it could earn by being invested in so e bond.

The speculative motive for demand for money arises when investing the money in some asset or bond is considered riskier than simply holding the money. The speculative motive for demand for money is also affected by the expected rise or fall of the future interest rates and inflation of the economy.

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If interest rates are expected to raise the opportunity cost of simply holding the money will also rise and reduce the speculative motive. And if inflation is expected to rise, money will lose its purchasing power and again speculative income will drop.

SUPPLY OF MONEY

Money supply is a stock concept. It refers to the entire stock of money (of all types) held by the people of a country at a point of time. Money supply includes only that stock of money which is held by people, other than the suppliers of money themselves. In other words, money supply refers to the stock of money held by the public or those who demand money.

Money supply does not include stock of money held by the government, and stock of money held by the banking system of a country. The government and the banking system of a country are suppliers of money or are the producers of money. Hence, money held by them is not a part of the stock of money held by the people.

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• Functions of Money and its Demand

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Components of the Money Supply

Two main components of the money supply are:

1. Currency (includes coins and notes) 2. Demand deposits

Currency

1. Coins: There were two types of coins – full bodied standard coins and token coin. Under Managed Currency System that prevails these days, full-bodied standard coins have little utility. Hence, these are no longer in circulation. Indian Rupee is neither a full-bodied standard coin nor is it a perfect token coin. Coins o the denomination of 50paisa, 25 paise, are token coins.

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2. Currency Notes: The government and the central bank of the country both issue the currency notes. In India, government issues One rupee note, while the Reserve Bank of India issues all other currency notes.

Alternative Measures of Money Supply (Money Stock)

In India, the Reserve Bank of India uses four alternative measures of money supply known as M1, M2, M3 and M4. M1 is the most frequently used measure of money supply because its components are regarded as the most liquid resources. Below is the explanation of each measure:

(i) M1 = C + DD + OD

Here C stands for currency (paper notes and coins) detained by the public, DD signify demand deposits in banks and OD denotes other deposits in RBI which includes demand deposits of public financial institutions, demand deposits of foreign central banks and international financial institutions like IMF, World Bank, etc. Demand deposits can be taken out at any time by the account holders. Current account deposits are integrated with demand deposits.

However, we do not include savings account deposits in DD for the reason that there exists certain conditions on the amount and number of withdrawals.

Also,

(ii) M2 = M1 (detailed on top of) + saving deposits with Post Office Saving Banks

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(iii) M3= M1 + Net Time-deposits of Banks

(iv) M4 = M3 + Total deposits with Post Office Saving Institute (excluding National Saving Certificate)

In fact, a great deal of discussion is still going on as to what constitutes money supply. Savings deposits of post offices are not a part of money supply for the reason that they do not provide a medium of exchange due to lack of cheque facility. In the same way, we do not count fixed deposits in commercial banks as money. As a result, M1 and M2 may be treated as measures of narrow money whereas M3 and M4 as measures of broad money.

M1 is used as the measure of money supply which is also called aggregate monetary resources of the general public. All the above four measures represent different degrees of liquidity, with M1 being the most liquid andM4 is being the least liquid. It is noteworthy here that liquidity means the ability to change an asset into money quickly and without loss of value

Important Facts about Measures of Money Supply

1. The four measures of money supply represent different degrees of liquidity, with M1 being the most liquid and M4 being the least liquid.

2. M1 is widely used as a measure of money supply and it is also known as ‘aggregate monetary resources of the general public’.

3. M1 and M2 are generally known as narrow money supply concepts, whereas, M3 and M4 are known as broad money supply concepts.

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IS-LM

The Goods Market and Money Market: Links between Them:

The Keynes in his analysis of national income explains that national

income is determined at the level where aggregate demand (i.e., aggregate

expenditure) for consumption and investment goods (C +1) equals aggregate

output.

In other words, in Keynes’ simple model the level of national income is shown

to be determined by the goods market equilibrium. In this simple analysis of

equilibrium in the goods market Keynes considers investment to be

determined by the rate of interest along with the marginal efficiency of capital

and is shown to be independent of the level of national income.

The rate of interest, according to Keynes, is determined by money market

equilibrium by the demand for and supply of money. In this Keynes’ model,

changes in rate of interest either due to change in money supply or change in

demand for money will affect the determination of national income and

output in the goods market through causing changes in the level of

investment.

In this way changes in money market equilibrium influence the determination

of national income and output in the goods market. However, there is

apparently one flaw in the Keynesian analysis which has been pointed out by

some economists and has been a subject of a good deal of controversy.

It has been asserted that in the Keynesian model whereas the changes in rate

of interest in the money market affect investment and therefore the level of

income and output in the goods market, there is seemingly no inverse

influence of changes in goods market i.e., (investment and income) on the

money market equilibrium.

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It has been shown by J.R. Hicks and others that with greater insights into the

Keynesian theory one finds that the changes in income caused by changes in

investment or propensity to consume in the goods market also influence the

determination of interest in the money market.

According to him, the level of income which depends on the investment and

consumption demand determines the transactions demand for money which

affects the rate of interest. Hicks, Hansen, Lerner and Johnson have put

forward a complete and integrated model based on the Keynesian framework

wherein the variables such as investment, national income, rate of interest,

demand for and supply of money are interrelated and mutually

interdependent and can be represented by the two curves called the IS and LM

curves.

This extended Keynesian model is therefore known as IS-LM curve model. In

this model they have shown how the level of national income and rate of

interest are jointly determined by the simultaneous equilibrium in the two

interdependent goods and money markets. Now, this IS-LM curve model has

become a standard tool of macroeconomics and the effects of monetary and

fiscal policies are discussed using this IS and LM curves model.

Goods Market Equilibrium: The Derivation of the IS Curve:

The IS-LM curve model emphasises the interaction between the goods

and money markets. The goods market is in equilibrium when aggregate

demand is equal to income. The aggregate demand is determined by

consumption demand and investment demand.

In the Keynesian model of goods market equilibrium we also now introduce

the rate of interest as an important determinant of investment. With this

introduction of interest as a determinant of investment, the latter now

becomes an endogenous variable in the model.

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When the rate of interest falls the level of investment increases and vice versa.

Thus, changes in the rate of interest affect aggregate demand or aggregate

expenditure by causing changes in the investment demand. When the rate of

interest falls, it lowers the cost c’ investment projects and thereby raises the

profitability of investment.

The businessmen will therefore undertake greater investment at a lower rate

of interest. The increase in investment demand will bring about increase in

aggregate demand which in turn will raise the equilibrium level of income. In

the derivation of the IS Curve we seek to find out the equilibrium level of

national income as determined by the equilibrium in goods market by a level

of investment determined by a given rate of interest.:

Thus IS curve relates different equilibrium levels of national income with

various rates of interest. As explained above, with a fall in the rate of interest,

the planned investment will increase which will cause an upward shift in

aggregate demand function (C + 7) resulting in goods market equilibrium at a

higher level of national income.

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The lower the rate of interest, the higher will be the equilibrium level of

national income. Thus, the IS curve is the locus of those combinations of rate

of interest and the level of national income at which goods market is in

equilibrium.

How the IS curve is derived is illustrated in Fig. 24.1. In panel (a) of Fig. 24.1

the relationship between rate of interest and planned investment is depicted

by the investment demand curve II. It will be seen from panel (a) that at rate

of interest Or0 the planned investment is equal to OI0. With OI0 as the amount

of planned investment, the aggregate demand curve is C + I0 which, as will be

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seen in panel (b) of Fig. 24.1 equals aggregate output at OY1 level of national

income.:

Therefore, in the panel (c) at the bottom of the Fig. 24.1, against rate of

interest Or2, level of income equal to OY0 has been plotted. Now, if the rate of

interest falls to Or2 the planned investment by businessmen increases from

OI0 to OI1 [see panel (a)]. With this increase in planned investment, the

aggregate demand curve shifts upward to the new position C + 11 in panel (b),

and the goods market is in equilibrium at OY1 level of national income. Thus,

in panel (c) at the bottom of Fig. 24.1 the level of national income OY1 is

plotted against the rate of interest, Or1. With further lowering of the rate of

interest to Or2, the planned investment increases to OI2 (see panel a). With this

further rise in planned investment the aggregate demand curve in panel (b)

shifts upward to the new position C + I2 corresponding to which goods market

is in equilibrium at OY2 level of income. Therefore, in panel (c) the equilibrium

income OY2 is shown against the interest rate Or2.

By joining points A, B, D representing various interest-income combinations

at which goods market is in equilibrium we obtain the IS Curve. It will be

observed from Fig. 24.1 that the IS Curve is downward sloping (i.e., has a

negative slope) which implies that when rate of interest declines, the

equilibrium level of national income increases.

Why does IS Curve Slope Downward?

What accounts for the downward-sloping nature of the IS curve. As seen

above, the decline in the rate of interest brings about an increase in the

planned investment expenditure. The increase in investment spending causes

the aggregate demand curve to shift upward and therefore leads to the

increase in the equilibrium level of national income. Thus, a lower rate of

interest is associated with a higher level of national income and vice-versa.

This makes the IS curve, which relates the level of income with the rate of

interest, to slope downward.

107

Steepness of the IS curve depends on (1) the elasticity of the investment

demand curve, and (2) the size of the multiplier. The elasticity of investment

demand signifies the degree of responsiveness of investment spending to the

changes in the rate of interest.

Suppose the investment demand is highly elastic or responsive to the changes

in the rate of interest, then a given fall in the rate of interest will cause a large

increase in investment demand which in turn will produce a large upward

shift in the aggregate demand curve.

A large upward shift in the aggregate demand curve will bring about a large

expansion in the level of national income. Thus when investment demand is

more elastic to the changes in the rate of interest, the investment demand

curve will be relatively flat (or less steep). Similarly, when investment demand

is not very sensitive or elastic to the changes in the rate of interest, the IS

curve will be relatively more steep.

The steepness of the IS curve also depends on the magnitude of the multiplier.

The value of multiplier depends on the marginal propensity to consume

(mpc). It may be noted that the higher the marginal propensity to consume,

the aggregate demand curve (C + I) will be more steep and the magnitude of

multiplier will be large.

In case of a higher marginal propensity to consume (mpc) and therefore a

higher value of multiplier, a given increment in investment demand caused by

a given fall in the rate of interest will help to bring about a greater increase in

equilibrium level of income.

Thus, the higher the value of multiplier, the greater will be the rise in

equilibrium income produced by a given fall in the rate of interest and this

makes the IS curve flatter. On the other hand, the smaller the value of

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multiplier due to lower marginal propensity to consume, the smaller will be

the increase in equilibrium level of income following a given increment in

investment caused by a given fall in the rate of interest. Thus, in case of

smaller size of multiplier the IS curve will be more steep.

Shift in IS Curve:

It is important to understand what determines the position of the IS curve and

what causes shifts in it. It is the level of autonomous expenditure which

determines the position of the IS curve and changes in the autonomous

expenditure cause a shift in it. By autonomous expenditure we mean the

expenditure, be it investment expenditure, the Government spending or

consumption expenditure which does not depend on the level of income and

the rate of interest.

The government expenditure is an important type of autonomous expenditure.

Note that the Government expenditure which is determined by several factors

as well as by the policies of the Government does not depend on the level of

income and the rate of interest.:

Similarly, some consumption expenditure has to be made if individuals have

to survive even by borrowing from others or by spending their savings made in

the past year. Such consumption expenditure is a sort of autonomous

expenditure and changes in it do not depend on the changes in income and

rate of interest. Further, autonomous changes in investment can also occur.

In the goods market equilibrium of the simple Keynesian model the

investment expenditure is treated as autonomous or independent of the level

of income and therefore does not vary as the level of income increases.

However, in the complete Keynesian model, the investment spending is

thought to be determined by the rate of interest along with marginal efficiency

of investment.

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Following this complete Keynesian model, in the derivation of the IS curve we

consider the level of investment and changes in it as determined by the rate of

interest along with marginal efficiency of capital. However, there can be

changes in investment spending autonomous or independent of the changes in

rate of interest and the level of income.

For instance, growing population requires more investment in house

construction, school buildings, roads, etc., which does not depend on changes

in level of income or rate of interest. Further, autonomous changes in

investment spending can also take place when new innovations come about,

that is, when there is progress in technology and new machines, equipment,

tools etc., have to be built embodying the new technology.:

Besides, Government expenditure is also of autonomous type as it does not

depend on income and rate of interest in the economy. As is well- known

government increases its expenditure for the purpose of promoting social

welfare and accelerating economic growth. Increase in Government

expenditure will cause a rightward shift in the IS curve.

Money Market Equilibrium: Derivation of LM Curve:

Derivation of the LM Curve:

The LM curve can be derived from the Keynesian theory from its analysis of

money market equilibrium. According to Keynes, demand for money to hold

depends upon transactions motive and speculative motive.

It is the money held for transactions motive which is a function of income. The

greater the level of income, the greater the amount of money held for

transactions motive and therefore higher the level of money demand curve.

The demand for money depends on the level of income because they have to

finance their expenditure, that is, their transactions of buying goods and

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services. The demand for money also depends on the rate of interest which is

the cost of holding money. This is because by holding money rather than

lending it and buying other financial assets, one has to forgo interest.

Thus demand for money (Md) can be expressed as:

Md – L(Y, r)

Where Md stands for demand for money, Y for real income and r for rate of

interest. Thus, we can draw a family of money demand curves at various levels

of income. Now, the intersection of these various money demand curves

corresponding to different income levels with the supply curve of money fixed

by the monetary authority would gives us the LM curve.

The LM curve relates the level of income with the rate of interest which is

determined by money-market equilibrium corresponding to different levels of

demand for money. The LM curve tells what the various rates of interest will

be (given the quantity of money and the family of demand curves for money)

at different levels of income.

But the money demand curve or what Keynes calls the liquidity preference

curve alone cannot tell us what exactly the rate of interest will be. In Fig. 24.2

(a) and (b) we have derived the LM curve from a family of demand curves for

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money. As

income increases, money demand curve shifts outward and therefore the rate

of interest which equates supply of money, with demand for money rises. In

Fig. 24.2 (b) we measure income on the X-axis and plot the income level

corresponding to the various interest rates determined at those income levels

through money market equilibrium by the equality of demand for and the

supply of money in Fig. 24.2 (a).

Slope of LM Curve:

It will be noticed from Fig. 24.2 (b) that the LM curve slopes upward to the

right. This is because with higher levels of income, demand curve for money

(Md) is higher and consequently the money- market equilibrium, that is, the

equality of the given money supply with money demand curve occurs at a

higher rate of interest. This implies that rate of interest varies directly with

income.

It is important to know the factors on which the slope of the LM curve

depends. There are two factors on which the slope of the LM curve depends.

First, the responsiveness of demand for money (i.e., liquidity preference) to

the changes in income. As the income increases, say from Y0 to Y1 the demand

curve for money shifts from Md0 to Md1 that is, with an increase in income,

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demand for money would increase for being held for transactions motive,

Md or L1 =f(Y).

This extra demand for money would disturb the money market equilibrium

and for the equilibrium to be restored the rate of interest will rise to the level

where the given money supply curve intersects the new demand curve

corresponding to the higher income level.

It is worth noting that in the new equilibrium position, with the given stock of

money supply, money held under the transactions motive will increase

whereas the money held for speculative motive will decline.

The greater the extent to which demand for money for transactions motive

increases with the increase in income, the greater the decline in the supply of

money available for speculative motive and, given the demand for money for

speculative motive, the higher the rise in tie rate of interest and consequently

the steeper the LM curve, r = f (M2 L2) where r is the rate of interest, M2 is the

stock of money available for speculative motive and L2 is the money demand or

liquidity preference for speculative motive.

The second factor which determines the slope of the LM curve is the elasticity

or responsiveness of demand for money (i.e., liquidity preference for

speculative motive) to the changes in rate of interest. The lower the elasticity

of liquidity preference for speculative motive with respect to the changes in

the rate of interest, the steeper will be the LM curve. On the other hand, if the

elasticity of liquidity preference (money demand-function) to the changes in

the rate of interest is high, the LM curve will be flatter or less steep.

Shifts in the LM Curve:

Another important thing to know about the IS-LM curve model is that what

brings about shifts in the LM curve or, in other words, what determines the

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position of the LM curve. As seen above, a LM curve is drawn by keeping the

stock or money supply fixed.

Therefore, when the money supply increases, given the money demand

function, it will lower the rate of interest at the given level of income. This is

because with income fixed, the rate of interest must fall so that demands for

money for speculative and transactions motive rises to become equal to the

greater money supply. This will cause the LM curve to shift outward to the

right.

The other factor which causes a shift in the LM curve is the change in liquidity

preference (money demand function) for a given level of income. If the

liquidity preference function for a given level of income shifts upward, this,

given the stock of money, will lead to the rise in the rate of interest for a given

level of income. This will bring about a shift in the LM curve to the left.

It therefore follows from above that increase in the money demand function

causes the LM curve to shift to the left. Similarly, on the contrary, if the money

demand function for a given level of income declines, it will lower the rate of

interest for a given level of income and will therefore shift the LM curve to the

right.

The LM Curve: The Essential Features:

From our analysis of the LM curve, we arrive at its following

essential features:

1. The LM curve is a schedule that describes the combinations of rate of

interest and level of income at which money market is in equilibrium.

2. The LM curve slopes upward to the right.

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3. The LM curve is flatter if the interest elasticity of demand for money is high.

On the contrary, the LM curve is steep if the interest elasticity demand for

money is low.

4. The LM curve shifts to the right when the stock of money supply is

increased and it shifts to the left if the stock of money supply is reduced.

5. The LM curve shifts to the left if there is an increase in the money demand

function which raises the quantity of money demanded at the given interest

rate and income level. On the other hand, the LM curve shifts to the right if

there is a decrease in the money demand function which lowers the amount of

money demanded at given levels of interest rate and income.

Simultaneous Equilibrium of the Goods Market and Money

Market:

The IS and the LM curves relate the two variables:

(a) Income and

(b) The rate of interest.

Income and the rate of interest are therefore determined together at the point

of intersection of these two curves, i.e., E in Fig. 24.3. The equilibrium rate of

interest thus determined is Or2 and the level of income determined is OY2. At

this point income and the rate of interest stand in relation to each other such

that (1) the goods market is in equilibrium, that is, the aggregate demand

equals the level of aggregate output, and (2) the demand for money is in

equilibrium with the supply of money (i.e., the desired amount of money is

equal to the actual supply of money). It should be noted that LM cur/e has

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been drawn by keeping the supply of money fixed.

Thus, the IS-LM curve model is based on:

(1) The investment-demand function,

(2) The consumption function,

(3) The money demand function, and

(4) The quantity of money.

We see, therefore, that according to the IS-LM curve model both the real

factors, namely, saving and investment, productivity of capital and propensity

to consume and save, and the monetary factors, that is, the demand for money

(liquidity preference) and supply of money play a part in the joint

determination of the rate of interest and the level of income. Any change in

these factors will cause a shift in IS or LM curve and will therefore change the

equilibrium levels of the rate of interest and income.

The IS-LM curve model explained above has succeeded in integrating the

theory of money with the theory of income determination. And by doing so, as

we shall see below, it has succeeded in synthesising the monetary and fiscal

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policies. Further, with the IS-LM curve analysis, we are better able to explain

the effect of changes in certain important economic variables such as desire to

save, the supply of money, investment, demand for money on the rate of

interest and level of income.

Effect of Changes in Supply of Money on the Rate of Interest and

Income Level:

Let us first consider what will happen if the supply of money is increased by

the action of the Central Bank. Given the liquidity preference schedule, with

the increase in the supply of money, more money will be available for

speculative motive at a given level of income which will cause the interest rate

to fall. As a result, the LM curve will shift to the right.

With this rightward shift in the LM curve, in the new equilibrium position,

rate of interest will be lower and the level of income greater than before. This

is shown in Fig. 24.4 where with a given supply of money, LM and IS curves

intersect at point E.

With the increase in the supply of money, LM curve shifts to the right to the

position LM’, and with IS schedule remaining unchanged, new equilibrium is

at point G corresponding to which rate of interest is lower and level of income

greater than at E. Now, suppose that instead of increasing the supply of

money, Central Bank of the country takes steps to reduce the supply of money.

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With the reduction in the supply of money, less money will be available for

speculative motive at each level of income and, as a result, the LM curve will

shift to the left of E, and the IS curve remaining un-changed, in the new

equilibrium position (as shown by point T in Fig. 24.4) the rate of interest will

be higher and the level of income smaller than before.

Changes in the Desire to Save or Propensity to Consume:

Let us consider what happens to the rate of interest when desire to save or in

other words, propensity to consume changes. When people’s desire to save

falls, that is, when propensity to consume rises, the aggregate demand curve

will shift upward and, therefore, level of national income will rise at each rate

of interest. As a result, the IS curve will shift outward to the right. In Fig. 24.5 suppose with a certain given fall in the

desire to save (or increase in the propensity to consume), the IS curve shifts

rightward to the dotted position IS’. With LM curve remaining unchanged, the

new equilibrium position will be established at H corresponding to which rate

of interest as well as level of income will be greater than at E.

Thus, a fall in the desire to save has led to the increase in both rate of interest

and level of income. On the other hand, if the desire to save rises, that is, if the

propensity to consume falls, aggregate demand curve will shift downward

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which will cause the level of national income to fall for each rate of interest

and as a result the IS curve will shift to the left.

With this, and LM curve remaining unchanged, the new equilibrium position

will be reached to the left of E, say at point L (as shown in Fig. 24.5)

corresponding to which both rate of interest and level of national income will

be smaller than at E.

Changes in Autonomous Investment and Government Expenditure:

Changes in autonomous investment and Government expenditure will also

shift the IS curve. If either there is increase in autonomous private investment

or Government steps up its expenditure, aggregate demand for goods will

increase and this will bring about increase in national income through the

multiplier process.

This will shift IS schedule to the right, and given the LM curve, the rate of

interest as well as the level of income will rise. On the contrary, if somehow

private investment expenditure falls or the Government reduces its

expenditure, the IS curve will shift to the left and, given the LM curve, both

the rate of interest and the level of income will fall.

Changes in Demand for Money or Liquidity Preference:

Changes in liquidity preference will bring about changes in the LM curve. If

the liquidity preference or demand for money of the people rises, the LM curve

will shift to the left. This is because, greater demand for money, given the

supply of money, will raise the rate of interest corresponding to each level of

national income. With the leftward shift in the LM curve, given the IS curve,

the equilibrium rate of interest will rise and the level of national income will

fall.

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On the contrary, if the demand for money or liquidity preference of the people

falls, the LM curve will shift to the right. This is because, given the supply of

money, the rightward shift in the money demand curve means that

corresponding to each level of income there will be lower rate of interest. With

rightward shift in the LM curve, given the IS curve, the equilibrium level of

rate of interest will fall and the equilibrium level of national income will

increase.

We thus see that changes in propensity to consume (or desire to save),

autonomous investment or Government expenditure, the supply of money and

the demand for money will cause shifts in either IS or LM curve and will

thereby bring about changes in the rate of interest as well as in national

income.

The integration of goods market and money market in the IS-LM curve model

clearly shows that Government can influence the economic activity or the level

of national income through monetary and fiscal measures.

Through adopting an appropriate monetary policy (i.e., changing the supply of

money) the Government can shift the LM curve and through pursuing an

appropriate fiscal policy (expenditure and taxation policy) the Government

can shift the IS curve. Thus both monetary and fiscal policies can play a useful

role in regulating the level of economic activity in the country.

Critique of the IS-LM Curve Model:

The IS-LM curve model makes a significant advance in explaining the

simultaneous determination of the rate of interest and the level of national

income. It represents a more general, inclusive and realistic approach to the

determination of interest rate and level of income.

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Further, the IS-LM model succeeds in integrating and synthesising fiscal with

monetary policies, and theory of income determination with the theory of

money. But the IS-LM curve model is not without limitations.

Firstly, it is based on the assumption that the rate of interest is quite flexible,

that is, free to vary and not rigidly fixed by the Central Bank of a country. If

the rate of interest is quite inflexible, then the appropriate adjustment

explained above will not take place.

Secondly, the model is also based upon the assumption that investment is

interest-elastic, that is, investment varies with the rate of interest. If

investment is interest-inelastic, then the IS-LM curve model breaks down

since the required adjustments do not occur.

Thirdly, Don Patinkin and Milton Friedman have criticised the IS-LM curve

model as being too, artificial and over-simplified. In their view, division of the

economy into two sectors – monetary and real – is artificial and unrealistic.

According to them, monetary and real sectors are quite interwoven and act

and react on each other.

Further, Patinkin has pointed out that the IS-LM curve model has ignored the

possibility of changes in the price level of commodities. According to him, the

various economic variables such as supply of money, propensity to consume or

save, investment and the demand for money not only influence the rate of

interest and the level of national income but also the prices of commodities

and services.

Patinkin has suggested a more integrated and general equilibrium approach

which involves the simultaneous determination of not only the rate of interest

and the level of income but also of the prices of commodities and services.

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IS-LM Curve Model: Explaining Role of Government’s Fiscal and

Monetary Policies:

With the help of IS-LM curve model we can explain how the intervention by

the Government with proper fiscal and monetary policies can influence the

level of economic activity, that is, income and employment level. We explain

below the impact of changes in fiscal and monetary policy on the economy in

the IS-LM model. Effect of Fiscal Policy:

Let us first explain how IS-LM model shows the effect of increase in

Government expenditure on level of income. This is illustrated in Fig. 24.6. As

explained above, increase in Government expenditure which is of autonomous

nature raises aggregate demand for goods and services and thereby causes an

outward shift in IS curve, as is shown in Fig. 24.6 where increase in

Government expenditure leads to the shift in IS curve from IS1to IS2 Note that

the horizontal distance between the two IS curves is equal to ∆G x 1/1 –MPC

which shows the increase in income that occurs in Keynes’s multiplier model. It

will be seen from Fig. 24.6 that with the LM curve remaining unchanged,

the new IS2 curve intersects LM curve at point B. Thus, in IS-LM model with

the increase in Government expenditure (AG), the equilibrium moves from

point E to B and with this the rate of interest rises from r1 to r2 and income

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level from Y1 to Y2. Thus, IS-LM model shows that expansionary fiscal policy of

increase in Government expenditure raises both the level of income and rate

of interest.

It is worth noting that in the IS-LM model increase in national income by

Y1Y2 in Fig. 24.6 is less than EK which would occur in Keynes’s model. This is

because Keynes in his simple multiplier model (popularly called Keynesian

cross model) assumes that investment is fixed and autonomous, whereas IS-

LM model takes into account the fall in private investment due to the rise in

interest rate that takes place with the increase in Government expenditure.

That is, increase in Government expenditure crowds out some private

investment.

Likewise, it can be illustrated that the reduction in Government expenditure

will cause a right- ward shift in the IS curve, and given the LM curve

unchanged, will lead to the fall in both rate of interest and level of income. It

should be noted that Government often cuts expenditure to control inflation in

the economy. Reduction in Taxes:

An alternative measure of expansionary fiscal policy which may be adopted is

the reduction in taxes which through increase in disposable income of the

people raises consumption demand of the people. As a result, cut in taxes

causes a shift in the IS curve to the right as is shown in Fig. 24.7, from IS1 to

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IS2. It may however noted that in the Keynesian multiplier model, the

horizontal shift in the IS curve is determined by the value of tax multiplier

which is equal to ∆T x MPC/1 – MPC and causes level of income to increase by

EH.

However, in the IS-LM model, with the shift of the IS curve from IS1 to

IS2 following the reduction in taxes, the economy moves from equilibrium

point E to D and as is evident from Fig. 24.7, rate of interest rises from r1 to

r2 and level of income increases from Y1 to Y2.

On the other hand, if the Government intervenes in the economy to reduce

inflationary pressures, it will raise the rates of personal taxes to reduce

disposable income of the people. Rise in personal taxes will lead to the

decrease in aggregate demand. Decrease in aggregate demand will help in

controlling inflation. This case can also be shown by IS-LM curve model.

Impact of Monetary Policy:

Through making appropriate changes in monetary policy the Government can

influence the level of economic activity. Monetary policy may also be

expansionary or contractionary depending on the prevailing economic

situation. IS-LM model can be used to show the effect of expansionary and

tight monetary policies. As has been explained above, a change in money

supply causes a shift in the LM curve; expansion in money supply shifts it to

the right and decrease in money supply shifts it to the left.

Suppose the economy is in grip of recession, the Government (through its

Central Bank) adopts the expansionary monetary policy to lift the economy

out of recession. Thus, it takes measures to increase the money supply in the

economy. The increase in money supply, state of liquidity preference or

demand for money remaining unchanged, will lead to the fall in rate of

interest.

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At a lower interest there will be more investment by businessmen. More

investment will cause aggregate demand and income to rise. This implies that

with expansion in money supply LM curve will shift to the right as is shown in

Fig. 24.8. As a result, the economy will

move from equilibrium point E to D and with this the rate of interest will fall

from r1 to r2 and national income will increase from Y1 to Y2.Thus, IS-LM model

shows the expansion in money supply lowers interest rate and raises income.

We have also indicated what is called monetary transmission mechanism, that

is, how IS-LM curve model shows the expansion in money supply leads to the

increase in aggregate demand for goods and services. We have thus seen that

increase in money supply lowers the rate of interest which then stimulates

more investment demand. Investment demand through multiplier process

leads to a greater increase in aggregate demand and national income.

If the economy suffers from inflation, the Government will like to check it.

Then its Central Bank should adopt tight or contractionary monetary policy.

That is, it should reduce the money supply. IS-LM model can be used to show,

as we have seen above in case of expansionary monetary policy, that reduction

in money supply will cause a leftward shift in LM curve and will lead to the

rise in interest rate and fall in the level of income - (ARTICLE BY – SUPRIYA

GURU)

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THE PHILLIPS CURVE The Phillips curve shows the relationship between unemployment

and inflation in an economy. Since its ‘discovery’ by New Zealand economist AW Phillips, it has become an essential tool to analyse macro- economic policy.

The Phillips curve and fiscal policy

After 1945, fiscal demand management became the general tool for managing the trade cycle. The consensus was that policy makers should stimulate aggregate demand (AD) when faced with recession and unemployment, and constrain it when experiencing inflation. It was also generally believed that economies faced either inflation or unemployment, but not together – and whichever existed would dictate which macro-economic policy objective to pursue at any given time. In addition, the accepted wisdom was that it was possible to target one objective, without having a negative effect on the other. However, following publication of Phillips’ research in 1958, both of these assumptions were called into question.

Phillips analysed annual wage inflation and unemployment rates in the UK for the period 1860 – 1957, and then plotted them on a scatter diagram. The data appeared to demonstrate an inverse and stable relationship between wage inflation and unemployment. Later economists substituted price inflation for wage inflation and the Phillips curve was born. When economists from other countries undertook similar research, they also found very similar curves for their own economies.

Phillips analysed annual wage inflation and unemployment rates in the UK for the period 1860 – 1957, and then plotted them on a scatter diagram.

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m

m

Explaining the Phillips curve

The curve suggested that changes in the

level of

unemployment have a

direct and predictable effect on the level of price inflation. The accepted explanation during the 1960’s was that a fiscal sti ulus, and increase in AD, would trigger the following sequence of responses:

1. An increase in the demand for labour as generates growth.

2. The pool of unemployed will fall.

government spending

3. Firms must compete for fewer workers by raising nominal wages. 4. Workers have greater bargaining power to seek out increases in

nominal wages. 5. Wage costs will rise. 6. Faced with rising

higher prices. wage costs, firms pass on these cost increases in

Exploiting the Phillips curve

It quickly became accepted that

policy-

akers could exploit the trade

off between unemployment and inflation meant a little less inflation.

– a little more unemployment

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During the 1960s and 70s, it was common practice for governments around the world to select a rate of inflation they wished to achieve, and then expand or contract the economy to obtain this target rate. This policy became known as stop-go, and relied strongly on fiscal policy to create the expansions and contractions required.

The breakdown of the Phillips curve

By the mid 1970s, it appeared that the Phillips Curve trade off no longer existed – there no longer seemed a stable pattern. The stable relationship between unemployment and inflation appeared to have broken down. It was possible to have a number of inflation rates for any given unemployment rate.

American economists Friedman and Phelps offered one explanation – namely that there is not one Phillips curve, but a series of short run Phillips Curves and a long run Phillips Curve, which exists at the natural rate of unemployment (NRU). Indeed, in the long-run, there is no trade-off between unemployment and inflation.

The new-Classical explanation – the importance of expectations

Although there are disagreements between new-Classical economists and monetarists, the general line of argument about the breakdown of the Phillips curve runs as follows.

Assume that the economy starts from an equilibrium position at point A, with inflation currently at zero, and unemployment at the natural rate of 10% (NRU = 10%). Secondly, given the public’s concern with unemployment, assume the government attempts to expand the economy

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quickly by way of a fiscal (or monetary) stimulus, so that AD increases and unemployment falls.

Initially, the economy moves to B, and there is a fall in unemployment to 3% (at U1) as jobs are created in the short term. H ving more bargaining power, workers bid-up their nominal wages. As wage costs rise, prices are driven-up to 2% (at P1). The effects of the stimulus to AD quickly wear out as inflation ero es any gains by households and firms. Real spending and output return to their previous levels, at the NRU.

According to the new-Classical view, what happens next depends upon whether the price inflation has been understood and expected – in which case there is no money illusion – or whether it is not expected – in which case, money illusion exists. If workers have bid-up their wages in nominal terms only, they have suffered from money illusion, falsely believing they will be better off – in this case, the economy will move back to point A at the NRU, but with inflation only a temporary phenomenon. However, if they understand that price inflation will erode the value of their nominal wage increases, they will bargain for a wage rise that compensates them for the price rise. Again, the economy will move back to the NRU (with unemployment at 10%), but this time carrying with it the embedded inflation rate of 2% an move to point C. The economy will hop to SRPC2 (which has a higher level of expected inflation – i.e. 2%, rather than 0%). Any further attempt to expand the economy by increasing AD will move the economy temporarily to D. However, in the long-run the economy will inevitably move back to the NRU.

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The conclusion drawn was that any attempt to push unemployment below its natural rate would cause accelerating inflation, with no long-term job gains. The only way to reverse this process would be to raise unemployment above the NRU so that workers revised their expectations of inflation downwards, and the economy moved to a lower short-run Phillips curve

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BUSINESS CYCLES

Business cycles are characterized by boom in one period and collapse

in the subsequent period in the economic activities of a country.

These fluctuations in the economic activities are termed as phases of business cycles.

The fluctuations are compared with ebb and flow. The upward and

downward fluctuations in the cumulative economic magnitudes of a

country show variations in different economic activities in terms of

production, investment, employment, credits, prices, and wages. Such

changes represent different phases of business cycles.

Different Phases of Business Cycles

There are basically two important phases in a business cycle that are

prosperity and depression. The other phases that are expansion, peak,

trough and recovery are intermediary phases.

Representation of Business Cycle

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The steady growth line represents the growth of economy when there are no

business cycles. On the other hand, the line of cycle shows the business

cycles that move up and down the steady growth line. The different phases

of a business cycle are explained below.

1. Expansion:

The line of cycle that moves above the steady growth line represents

the expansion phase of a business cycle. In the expansion phase, there is an

increase in various economic factors, such as production, employment,

output, wages, profits, demand and supply of products, and sales.

In addition, in the expansion phase, the prices of factor of production and

output increases simultaneously. In this phase, debtors are generally in

good financial condition to repay their debts; therefore, creditors lend

money at higher interest rates. This leads to an increase in the flow of

money.

In expansion phase, due to increase in investment opportunities, idle funds

of organizations or individuals are utilized for various investment purposes.

Therefore, in such a case, the cash inflow and outflow of businesses are

equal. This expansion continues till the economic conditions are favorable.

2. Peak:

The growth in the expansion phase eventually slows down and reaches to its peak. This phase is known as peak phase. In other words,

peak phase refers to the phase in which the increase in growth rate of

business cycle achieves its maximum limit. In peak phase, the economic

factors, such as production, profit, sales, and employment, are higher, but

do not increase further. In peak phase, there is a gradual decrease in the

demand of various products due to increase in the prices of input.

The increase in the prices of input leads to an increase in the prices of final products, while the income of individuals remains constant. This also leads

consumers to restructure their monthly budget. As a result, the demand for

products, such as jewellery, homes, automobiles, refrigerators and other

durables, starts falling.

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3. Recession:

As discussed earlier, in peak phase, there is a gradual decrease in the demand of various products due to increase in the prices of input. When the

decline in the demand of products becomes rapid and steady, the recession

phase takes place.

In recession phase, all the economic factors, such as production, prices,

saving and investment, starts decreasing. Generally, producers are unaware

of decrease in the demand of products and they continue to produce goods

and services. In such a case, the supply of products exceeds the demand.

Over the time, producers realize the surplus of supply when the cost of

manufacturing of a product is more than profit generated. This condition

firstly experienced by few industries and slowly spread to all industries.

This situation is firstly considered as a small fluctuation in the market, but

as the problem exists for a longer duration, producers start noticing it.

Consequently, producers avoid any type of further investment in factor of

production, such as labor, machinery, and furniture. This leads to the

reduction in the prices of factor, which results in the decline of demand of

inputs as well as output.

4. Trough:

During the trough phase, the economic activities of a country decline

below the normal level. In this phase, the growth rate of an economy

becomes negative. In addition, in trough phase, there is a rapid decline in

national income and expenditure.

In this phase, it becomes difficult for debtors to pay off their debts. As a

result, the rate of interest decreases; therefore, banks do not prefer to lend

money. Consequently, banks face the situation of increase in their cash

balances.

Apart from this, the level of economic output of a country becomes low and

unemployment becomes high. In addition, in trough phase, investors do

not invest in stock markets. In trough phase, many weak organizations

leave industries or rather dissolve. At this point, an economy reaches to the

lowest level of shrinking.

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5. Recovery:

As discussed above, in trough phase, an economy reaches to the lowest level of shrinking. This lowest level is the limit to which an economy shrinks.

Once the economy touches the lowest level, it happens to be the end of

negativism and beginning of positivism.

This leads to reversal of the process of business cycle. As a result,

individuals and organizations start developing a positive attitude toward

the various economic factors, such as investment, employment, and

production. This process of reversal starts from the labor market.

Consequently, organizations discontinue laying off individuals and start

hiring but in limited number. At this stage, wages provided by

organizations to individuals is less as compared to their skills and abilities.

This marks the beginning of the recovery phase.

In recovery phase, consumers increase their rate of consumption, as they

assume that there would be no further reduction in the prices of products.

As a result, the demand for consumer products increases.

In addition in recovery phase, bankers start utilizing their accumulated

cash balances by declining the lending rate and increasing investment in

various securities and bonds. Similarly, adopting a positive approach other

private investors also start investing in the stock market As a result,

security prices increase and rate of interest decreases.

Price mechanism plays a very important role in the recovery phase of

economy. As discussed earlier, during recession the rate at which the price

of factor of production falls is greater than the rate of reduction in the

prices of final products.

Therefore producers are always able to earn a certain amount of

profit, which increases at trough stage. The increase in profit also continues

in the recovery phase. Apart from this, in recovery phase, some of the

depreciated capital goods are replaced by producers and some are

maintained by them. As a result, investment and employment by

organizations increases. As this process gains momentum an economy

again enters into the phase of expansion. Thus, a business cycle gets

completed

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BALANCE OF PAYMENT

Balance Of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases.

BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, BOP deficit indicates that a country’s imports are more than its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.

Why balance of payment is vital for a country?

A country’s BOP is vital for the following reasons:

• BOP of a country reveals its financial and economic status. • BOP statement can be used as an indicator to determine whether the

country’s currency value is appreciating or depreciating. • BOP statement helps the Government to decide on fiscal and trade

policies. • It provides important information to analyze and understand the

economic dealings of a country with other countries.

By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.

Elements of balance of payment

There are three components of balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.

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Current Account

The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they make up to a country’s Balance Of Trade (BOT).

There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries are referred to as visible items and import/export of services (banking, information technology etc) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This can also be personal transfers like – money sent by relatives to their family located in another country.

Capital Account

All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving out/in to a different country. The deficit or surplus in the current account is managed through the finance from capital account and vice versa.

There are 3 major elements of capital account:

• Loans & borrowings – It includes all types of loans from both the private and public sectors located in foreign countries.

• Investments – These are funds invested in the corporate stocks by non-residents.

• Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.

Financial Account

The flow of funds from and to foreign countries through various investments in real estates, business ventures, foreign direct investments etc is monitored through the financial account. This account measures the

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changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. On analyzing these changes, it can be understood if the country is selling or acquiring more assets (like gold, stocks, equity etc).

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MONETARY POLICY

1. Objective of the Monetary Policy

Following are the main objectives of monetary policy:

i. To Regulate Money Supply in the Economy:

Money supply includes both money in circulation and credit creation by

banks. Monetary policy is farmed to regulate the money supply in the

economy by credit expansion or credit contraction. By credit expansion (giving

more loans), the money supply can be expanded. By credit contraction (giving

less loans) money supply can be decreased.

The main aim of the monetary policy of the Reserve Bank was to control the

money supply in such a manner as to expand it to meet the needs of economic

growth and at the same time contract it to curb inflation. In other words

monetary policy aimed at expanding and contracting money supply according

to the needs of the economy.

ii. To Attain Price Stability:

Another major objective of monetary policy in India is to maintain price

stability in the country. It implies Control over inflation. Price level, is affected

by money supply. Monetary policy regulates money supply to maintain price

stability.

iii. To promote Economic Growth:

An important objective of monetary policy is to make available

necessary supply of money and credit for the economic growth of the country.

Those sectors which are quite significant for the economic growth are

provided with adequate availability of credit.

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iv. To Promote saving and Investment:

By regulating the rate of interest and checking inflation, monetary policy

promotes saving and investment. Higher rates of interest promote saving and

investment.

v. To Control Business Cycles:

Boom and depression are the main phases of business cycle. Monetary

policy puts a check on boom and depression. In period of boom, credit is

contracted, so as to reduce money supply and thus check inflation. In period of

depression, credit is expanded, so as to increase money supply and thus

promote aggregate demand in the economy.

vi. To Promote Exports and Substitute Imports:

By providing concessional loans to export oriented and import

substitution units, monetary policy encourages such industries and thus help

to improve the position of balance of payments.

vii. To Manage Aggregate Demand:

Monetary authority tries to keep the aggregate demand in balance with

aggregate supply of goods and services. If aggregate demand is to be increased

than credit is expanded and the interest rate is lowered down. Because of low

interest rate, more people take loan to buy goods and services and hence

aggregate demand increases and vice-verse.

viii. To Ensure more Credit for Priority Sector:

Monetary policy aims at providing more funds to priority sector by

lowering interest rates for these sectors. Priority sector includes agriculture,

small- scale industry, weaker sections of society, etc.

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ix. To Promote Employment:

By providing concessional loans to productive sectors, small and medium

entrepreneurs, special loan schemes for unemployed youth, monetary policy

promotes employment.

x. To Develop Infrastructure:

Monetary policy aims at developing infrastructure. It provides

concessional funds for developing infrastructure.

xi. To Regulate and Expand Banking:

RBI regulates the banking system of the economy. RBI has expanded

banking to all parts of the country. Through monetary policy, RBI issues

directives to different banks for setting up rural branches for promoting

agricultural credit. Besides it, government has also set up cooperative banks

and regional rural banks. All this has expanded banking in all parts of the

country.

3. Monetary Framework Process

Section 45ZB of the revised RBI Act, 1934 provides for an authorised six- member monetary policy committee (MPC) to be founded by the Central Government by notification in the Official Gazette. Therefore, the Central Government in September 2016 constituted the MPC as under:

1. Governor of the RBI – Chairperson, ex officio. 2. Deputy Governor of the RBI, in charge of Monetary Policy – Member,

ex officio. 3. One officer of the RBI to be nominated by the Central Board –

Member, ex officio. 4. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI) –

Member; 5. Professor Pami Dua, Director, Delhi School of Economics – Member;

and 6. Dr. Ravindra H. Dholakia, Professor, Indian Institute of

Management, Ahmedabad (IIMA) – Member.

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The RBI’s Monetary Policy Department (MPD) supports the MPC in framing the monetary policy. Views of important stakeholders in the economy, and logical work of the RBI add to the process for arriving at a decision on the policy repo rate. The Financial Markets Operations Department (FMOD) operationalises the financial policy through the daily liquidity management operations. The Financial Markets Committee (FMC) meets on a day-to-day basis to evaluate the liquidity conditions to ensure that the working target of the weighted average call money rate (WACR). Before the MPC was constituted, a Technical Advisory Committee (TAC) on the monetary policy with specialists from fiscal economics, financial markets, central banking, and public finance advised the Reserve Bank on the stance of monetary framework. Though, its role was only advisory in nature. With the formation of MPC, the TAC on Monetary Policy ceased to exist.

4. Monetary Policy Instruments

There are numerous direct and indirect instruments used for executing monetary policy, which are as follows:

• Repo Rate: The fixed interest rate which the RBI provides to lend instant money to banks against the government security and other approved collaterals under the liquidity adjustment facility (LAF).

• Reverse Repo Rate: The fixed interest rate at which the RBI absorbs liquidity, on an instant basis, from banks against the security of eligible government securities under the LAF.

• Liquidity Adjustment Facility (LAF): The LAF comprises overnight and term repo auctions. Gradually, the RBI has increased the amount of liquidity injected under the modified variable rate repo auctions of range of tenors. The objective of term repo is to help develop the interbank term money market, which can set market based standards for loan prices and deposits, and hence develop transmission of monetary policy. The RBI also offers variable interest rate reverse repo auctions, as imposed under the market conditions.

• Marginal Standing Facility (MSF): A facility under which planned commercial banks can lend extra amount of immediate cash from the RBI by dipping into their Statutory Liquidity Ratio (SLR) collection up till a limit at a penal rate of interest. This, in turn,

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provides a safety valve against unexpected liquidity shocks to the banking system.

• Corridor: The MSF rate and reverse repo rate regulate the corridor for the daily movement in the weighted average call money rate.

• Bank Rate: It’s the rate at which the RBI is ready to purchase or rediscount invoices of exchange or other commercial papers. The bank rate is available under Section 49 of the Reserve Bank of India Act, 1934. The rate is associated with the MSF rate and changes automatically as and when the MSF rate changes along with the policy repo rate changes.

• Cash Reserve Ratio (CRR): The average day-to-day balance a bank is required to sustain with the RBI as a share of such per cent of its net demand and time liabilities (NDTL) that the RBI may advise from time to time in the Gazette of India.

• Statutory Liquidity Ratio (SLR): The share of NDTL a bank is required to retain in safe and liquid assets, such as tangential government securities, cash, and gold. Variations in SLR often affect the availability of resources in the banking system for lending to the private sector.

• Open Market Operations (OMOs): These include outright purchase and transaction of government securities, for injection and absorption of durable liquidity, respectively.

• Market Stabilisation Scheme (MSS): This tool for monetary supervision was introduced in 2004. Excess liquidity of a more lasting nature arising from the inflow of large capital is absorbed via sale of short-dated government collaterals and treasury bills. The cash received is held in a separate government account with the RBI.

5. Open and Clear Monetary Policy Making

Under the modified RBI Act, the monetary framework making is as under:

• The MPC should meet at least four times in a year. • The minimum number of members for the meeting of the MPC is

four. • Each MPC member gets one vote, and in case of an equality of votes,

the Governor has a casting or second vote. • The purpose adopted by the MPC is printed after the conclusion of

every meeting of the MPC as per the provisions of Chapter III F of the Reserve Bank of India Act, 1934.

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On the 14th day, the minutes of the meeting of the MPC are printed, which are as follows:

• The resolution adopted by the MPC. • The vote of each member on the resolution, ascribed to such member. • The statement of each member on the resolution adopted.

Once in every six months, the RBI is should publish a document called the Monetary Policy Report to explain:

• The sources of inflation. • The prediction of inflation for 6-18 months ahead.

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FISCAL POLICY Fiscal policy deals with the taxation and expenditure decisions of the

government. Some of the major instruments of fiscal policy are as follows: Budget, Taxation, Public Expenditure, public revenue, Public Debt, and Fiscal Deficit in the economy.

Fiscal policy means the use of taxation and public

expenditure by the government for stabilization or growth of the economy. According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and expenditures which ordinarily as measured by the government’s receipts, its surplus or deficit.” The government may change undesirable variations in private consumption and investment by compensatory variations of public expenditures and taxes.

Fiscal policy also feeds into economic trends and influences monetary policy. When the government receives more than it spends, it has a surplus. If the government spends more than it receives it runs a deficit. To meet the additional expenditures, it needs to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount of money. This tends to influence other economic variables. On a broad generalization, excessive printing of money leads to inflation. If the government borrows too much from abroad it leads to a debt crisis. Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to

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access funds resulting in the “crowding out” of private investment. So it can be said that the fiscal deficit can be like a double edge sword, which need to be tackled very carefully.

Main Objectives of Fiscal Policy in India Before moving on the discussion on objectives of India’s Fiscal Policies, firstly know that the general objective of Fiscal Policy.

General objectives of Fiscal Policy are given below: 1. To maintain and achieve full employment. 2. To stabilize the price level. 3. To stabilize the growth rate of the economy. 4. To maintain equilibrium in the Balance of Payments. 5. To promote the economic development of underdeveloped countries.

Fiscal policy of India always has two objectives, namely improving the

growth performance of the economy and ensuring social justice to the people. The fiscal policy is designed to achieve certain objectives as follows:- 1. Development by effective Mobilisation of Resources: The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources. The central and state governments in India have used fiscal policy to mobilise resources. The financial resources can be mobilised by:-

a) Taxation: Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.

b) Public Savings: The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.

c) Private Savings: Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issuance of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

2. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social justice by reducing income inequalities

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among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items which are mostly consumed by the upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society.

3. Price Stability and Control of Inflation: One of the main objectives of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by reducing fiscal deficits, introducing tax savings schemes, productive use of financial resources, etc.

4. Employment Generation: The government is making every possible effort to increase employment in the country through effective fiscal measures. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generate more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons in the urban areas.

5. Balanced Regional Development: there are various projects like building up dams on rivers, electricity, schools, roads, industrial projects etc run by the government to mitigate the regional imbalances in the country. This is done with the help of public expenditure.

6. Reducing the Deficit in the Balance of Payment: some time government gives export incentives to the exporters to boost up the export from the country. In the same way import curbing measures are also adopted to check import. Hence the combine impact of these measures is improvement in the balance of payment of the country.

7. Increases National Income: it’s the strength of the fiscal policy that is brings out the desired results in the economy. When the government want to increase the income of the country then it increases the direct and indirect taxes rates in the country. There are some other measures like: reduction in tax rate so that more peoples get motivated to deposit actual tax.

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8. Development of Infrastructure: when the government of the concerned country spends money on the projects like railways, schools, dams, electricity, roads etc to increase the welfare of the citizens, it improves the infrastructure of the country. A improved infrastructure is the key to further speed up the economic growth of the country.

9. Foreign Exchange Earnings: when the central government of the country gives incentives like, exemption in custom duty, concession in excise duty while producing things in the domestic markets, it motivates the foreign investors to increase the investment in the domestic country.

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ROLE OF FISCAL POLICY IN CONTROLLING

INFLATION

The economy’s levels of output, employ-ment, and income are

influenced by the rela-tionship between the amount that the govern-ment

levies in taxes and the amount that it spends. A change in either taxes or

spending may induce an expansion or contraction in the economy.

Changes in taxes and/or government spending to control unemployment or

demand- pull inflation are termed fiscal policy.

Fiscal policy has evolved largely from the theories of J. M. Keynes, who

focused on the relationship between aggregate spending and the level of

economic activity, and suggested that the government could fill in a

spending gap created by a lack of private spending.

The Mechanics of Fiscal Policy:

Very simply, increases or decreases in total spending due to changes in

taxes and/or government expenditures can lead to expan-sions or

contractions in economic activity.

If there is high unemployment, policy-makers can take action to increase

the level of aggregate spending and, consequently, the level of economic

activity.

This increased spending could come from:

(1) Increased government purchases of goods and services, and/or

(2) Increased transfer payments, and/or

(3) Decreased taxes.

These three actions could be taken separately or in combination.

each of these actions can cause economic activity to grow, the

expansionary impact of increasing government purchases by a particular

amount is greater than the expansionary impact of increasing transfers or

decreasing taxes by the same amount. All of the rupees spent on

government purchases are injected directly into the spending stream,

whereas increased transfers and decreased taxes provide additional income — part of which will be spent but part of which will be saved.

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If the economy is experiencing demand- pull inflation, the appropriate

fiscal policy action for lowering the inflation rate is to decrease aggregate

spending.

Excess spending could be removed from the economy by:

(1) Decreasing government purchases of goods and services,

and/or (2) Decreasing transfer payments, and/or

(3) Increasing taxes.

Again, a more sharp decrease in spending results from a decrease in

government purchases because some of the reduced transfers and increased

taxes would affect saving rather than spending.

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NON-BANKING FINANCIAL COMPANY

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).

What is difference between banks & NBFCs?

NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as given below:

• NBFC cannot accept demand deposits; • NBFCs do not form part of the payment and settlement system and

cannot issue cheques drawn on itself; • deposit insurance facility of Deposit Insurance and Credit Guarantee

Corporation is not available to depositors of NBFCs, unlike in case of banks.

NBFCs are categorized

• in terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs,

• non deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-NDSI and NBFC- ND) and

• by the kind of activity they conduct.

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Within this broad categorization the different types of NBFCs

are as follows:

1. Asset Finance Company (AFC) : An AFC is a company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive/economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising there from is not less than 60% of its total assets and total income respectively.

2. Investment Company (IC) : IC means any company which is a financial institution carrying on as its principal business the acquisition of securities,

3. Loan Company (LC): LC means any company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but does not include an Asset Finance Company.

4. Infrastructure Finance Company (IFC): IFC is a non-banking finance company a) which deploys at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds of Rs 300 crore, c) has a minimum credit rating of ‘A ‘or equivalent d) and a CRAR of 15%.

5. Systemically Important Core Investment Company (CIC- ND-SI): CIC-ND-SI is an NBFC carrying on the business of acquisition of shares and securities.

6. Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC) : IDF-NBFC is a company registered as NBFC to facilitate the flow of long term debt into infrastructure projects. IDF- NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5 year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-NBFCs.

7. Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is a non-deposit taking NBFC having not less than 85% of its assets in the nature of qualifying assets which satisfy the following criteria:

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✓ a. loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding Rs 1,00,000 or urban and semi-urban household income not exceeding Rs 1,60,000;

✓ loan amount does not exceed Rs 50,000 in the first cycle and Rs

1,00,000 in subsequent cycles; ✓ total indebtedness of the borrower does not exceed Rs

1,00,000; ✓ tenure of the loan not to be less than 24 months for loan

amount in excess of Rs 15,000 with prepayment without penalty;

✓ loan to be extended without collateral; ✓ aggregate amount of loans, given for income generation, is not

less than 50 per cent of the total loans given by the MFIs; ✓ loan is repayable on weekly, fortnightly or monthly instalments

at the choice of the borrower

8. Non-Banking Financial Company – Factors (NBFC- Factors): NBFC-Factor is a non-deposit taking NBFC engaged in the principal business of factoring. The financial assets in the factoring business should constitute at least 50 percent of its total assets and its income derived from factoring business should not be less than 50 percent of its gross income.

9. Mortgage Guarantee Companies (MGC) - MGC are financial institutions for which at least 90% of the business turnover is mortgage guarantee business or at least 90% of the gross income is from mortgage guarantee business and net owned fund is Rs 100 crore.

10. NBFC- Non-Operative Financial Holding Company (NOFHC) is financial institution through which promoter / promoter groups will be permitted to set up a new bank .It’s a wholly-owned Non- Operative Financial Holding Company (NOFHC) which will hold the bank as well as all other financial services companies regulated by RBI or other financial sector regulators, to the extent permissible under the applicable regulatory prescriptions.

What action can be taken against persons/financial companies

making false claim of being regulated by the Reserve Bank?

It is illegal for any financial entity or unincorporated body to make a false claim of being regulated by the Reserve Bank to mislead the public to collect deposits and is liable for penal action under the Indian Penal Code.

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Information in this regard may be forwarded to the nearest office of the Reserve Bank and the Police.

What precautions should a depositor take before placing deposit

with an NBFC?

A depositor wanting to place deposit with an NBFC must take the following precautions before placing deposits:

1. That the NBFC is registered with RBI and specifically authorized by the RBI to accept deposits. A list of deposit taking NBFCs entitled to accept deposits is available at www.rbi.org.in. The depositor should check the list of NBFCs permitted to accept public deposits and also check that it is not appearing in the list of companies prohibited from accepting deposits.

2. NBFCs have to prominently display the Certificate of Registration (CoR) issued by the Reserve Bank on its site. This certificate should also reflect that the NBFC has been specifically authorized by RBI to accept deposits. Depositors must scrutinize the certificate to ensure that the NBFC is authorized to accept deposits.

3. The maximum interest rate that an NBFC can pay to a depositor should not exceed 12.5%. The Reserve Bank keeps altering the interest rates depending on the macro-economic environment. The Reserve Bank publishes the change in the interest rates on www.rbi.org.in → Sitemap → NBFC List → FAQs.

4. The depositor must insist on a proper receipt for every amount of deposit placed with the company. The receipt should be duly signed by an officer authorized by the company and should state the date of the deposit, the name of the depositor, the amount in words and figures, rate of interest payable, maturity date and amount.

5. In the case of brokers/agents etc collecting public deposits on behalf of NBFCs, the depositors should satisfy themselves that the brokers/agents are duly authorized by the NBFC.

6. The depositor must bear in mind that public deposits are unsecured and Deposit Insurance facility is not available to depositors of NBFCs.

7. The Reserve Bank of India does not accept any responsibility or guarantee about the present position as to the financial soundness of the company or for the correctness of any of the statements or representations made or opinions expressed by the company and for repayment of deposits/discharge of the liabilities by the company.

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Is the conducting of Chit Fund business permissible under law?

The chit funds are governed by Chit Funds Act, 1982 Which is a Central Act administered by state governments. Those chit funds which are registered under this Act can legally carry on chit fund business.

What are money circulation/Ponzi/multi-level marketing

schemes?

Money circulation, multi level marketing / Chain Marketing or Ponzi schemes are schemes promising easy or quick money upon enrollment of members. Income under Multi level marketing or pyramid structured schemes do not come from the sale of products they offer as much as from enrolling more and more members from whom hefty subscription fees are taken. It is incumbent upon all members to enroll more members, as a portion of the subscription amounts so collected are distributed among the members at the top of the pyramid. Any break in the chain leads to the collapse of the pyramid, and the members lower in the pyramid are the ones that are affected the most. Ponzi schemes are those schemes that collect money from the public on promises of high returns. As there is no asset creation, money collected from one depositor is paid as returns to the other. Since there is no other activity generating returns, the scheme becomes unviable and impossible for the people running the scheme to meet the promised return or even return the principal amounts collected. The scheme inevitably fails and the perpetrators disappear with the money.